Exchange Rate vs. Inflation Target
The Canadian dollar is again becoming more overvalued. After dipping as low as 92 US cents at the end of October, it rocketed up to 96 US cents so far today.
Meanwhile, the OECD has released another month of purchasing-power data. Although the loonieâ€™s average price on foreign-exchange markets edged up between August and September, its relative buying power in Canada edged down from 89 to 88 US cents.
These figures have two implications. First, while the loonieâ€™s appreciation is hurting Canadian producers, it does not appear to be helping Canadian consumers. Second, the gap between foreign-exchange markets and the real economy seems to be widening.
A couple of weeks ago, there was much public debate about whether the Bank of Canada should intervene to lower the exchange rate into line with fundamentals. This debate culminated with CIBCâ€™s Avery Shenfeld calling for intervention in an eloquent and persuasive note. The Globe and Mail kindlyÂ noted that I had been making this case for a few months.
On the same day, Governor Mark Carney appeared before the House of Commons Finance Committee to pour cold water on the possibility of intervention. The Globeâ€™s headline captured his basic message: â€œCarneyâ€™s inflation target trumps currency concerns.â€ I have two responses to this position.
Central Bank Mandate
For a couple of decades, Canadian central bankers have asserted â€“ and Canadian finance ministers have accepted â€“ that the Bank of Canadaâ€™s sole function is to control inflation. However, as I pointed out in The Toronto Star report on Carneyâ€™s testimony, the preamble to the legislation establishing the Bank of Canada outlines a far broader mandate, explicitly including exchange rates:
WHEREAS it is desirable to establish a central bank in Canada to regulate credit and currency in the best interests of the economic life of the nation, to control and protect the external value of the national monetary unit and to mitigate by its influence fluctuations in the general level of production, trade, prices and employment, so far as may be possible within the scope of monetary action, and generally to promote the economic and financial welfare of Canada.
In some circumstances, controlling inflation undoubtedly should take precedence over managing exchange rates. But there is no reason to accept an axiom that it always does.
However, even if one does accept 2% inflation as the Bank of Canadaâ€™s only legitimate goal, there is still a strong case for intervention in foreign-exchange markets. The July Monetary Policy Report, which foresaw an 87-cent dollar, projected a return to 2% inflation in the second quarter of 2011.
The October Monetary Policy Report foresees a 96-cent dollar. As a result, reaching 2% will take until the third quarter of 2011.
A higher exchange rate is causing Canadian inflation to fall further below the target for longer. The seemingly obvious implication is that the Bank of Canada could hit its inflation target sooner by lowering the exchange rate.
Today, the supposed conflict between controlling inflation and managing exchange rates is a false dichotomy. Currency intervention would serve both goals, as I argued in the following Financial Post letter:Â
Re: Currency Intervention, Oct. 28.
The “Con” half of your article presented two main arguments against intervention, neither of which was persuasive.
First, foreign exchange markets are so large that the Bank of Canada would need quantitative easing to bring down our dollar. This point is hardly an argument against intervention. Quantitative easing might increase inflation, but such an increase would actually help the Bank of Canada in moving from today’s negative inflation to its positive two-percent target.
Second, devaluing the Canadian dollar could allegedly validate China’s currency manipulation and provoke other countries to undertake such “beggar-thy-neighbour” devaluations. However, the key issue is that our dollar is now significantly overvalued relative to purchasing power parity and other measures. Intervening to bring Canada’s currency into line with fundamentals would neither justify China’s intervention to keep its currency substantially undervalued nor prompt other nations to replicate Chinese policy.
Erin Weir, Economist, United Steelworkers, Toronto