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 loonie’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 loonie’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 CIBC’s Avery Shenfeld calling for intervention in an eloquent and persuasive note. The Globe and Mail kindly 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 Globe’s headline captured his basic message: “Carney’s inflation target trumps currency concerns.” I have two responses to this position.

Central Bank Mandate

For a couple of decades, Canadian central bankers have asserted – and Canadian finance ministers have accepted – that the Bank of Canada’s sole function is to control inflation. However, as I pointed out in The Toronto Star report on Carney’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.

Inflation Target

However, even if one does accept 2% inflation as the Bank of Canada’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: 

Necessary step

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

5 comments

  • Erin:
    Just wondering what kind of intervention you had in mind. Avery Shenfeld points out that plants can be permanently lost as a result of a few years of an overvalued currency, yet in the end he only calls for “intervention at extremes“ “to chase away speculative flows“, presumably given some of the problems of sustained currency intervention.

    Punishing speculators is easy enough and makes sense. However maintaining the Canadian $ at a low level for a long period when it would otherwise be higher amounts to a subsidy to exports borne by all Canadians. While the exchange rate pass-through is not what it once was for many goods, at the very least it would mean oil, natural gas and imported basic food would increase in price proportionately to the decrease in the value of the Canadian $. It would also increase the cost of the imported inputs of exports, as you point out in your interesting paper linked elsewhere.

    It also means giving up the ability for a made-in-Canada interest rate policy. Although if it was a one-sided peg, only to the down-side, you could argue that a Canadian rate lower than the US rate might be a good thing.

    Rather than maintain a peg wouldn’t it be better to increase federal government spending substantially thereby increasing aggregate demand in Canada, resulting in downward pressure on the dollar. I guess I find increased EI, public pharmacare, public childcare, improved pensions, etc, a more appealing way to lower the $. An additional and complementary way would be to reduce our oil and gas exports to more sensible levels through the regulatory tools we have at the National Energy Board.

    I grant you that given the federal government we have such things are pretty unlikely (to put it mildly).
    Nonetheless it does seem a bit ironic to me that we are asking the Bank of Canada to bail us out of our inability to effect political change. Keep in mind the Bank didn’t intervene even when our dollar hit 1.09 US a couple of years ago…

  • Untill the US Dollar hits a technical bottom & has a sustained consolidation, or rally, we dont know how many times or how long our Central Bank would have to intervene. If the FED ever raises interest rates then a peg or currency intervention would be beneficial. To put it bluntly the US can borrow more, spend more then we can. We cannot intervene against a genuine weak dollar trend till that trend has run its course or do we want to help further global imbalances in world trade like China & others who manipulate their currencies. The US will have a weaker dollar & they will become competitive again, but if countries act like China the US bilateral trade deficit will increase. How does a progressive forget to take in account the USD has not hit a bottom.

  • I take Brandon’s point that US-dollar weakness has been a major part of the story. But the Canadian dollar appreciated much more than the American dollar depreciated. I think that the Bank of Canada can and should intervene (repeatedly if necessary) to limit this excess appreciation.

    For the reasons Keith outlines, a permanently and dramatically lower exchange rate is no panacea. However, I would distinguish between the long and short term.

    To the extent that we do want a lower exchange rate in the longer term, I agree with Keith, Travis and Jim that the best policy levers may be outside the monetary sphere (e.g. resource management and fiscal policy). But I still support immediate intervention in foreign-exchange markets to keep a lid on the loonie in the short term.

  • @Erin

    I understand but, if we were to intervene, the American consumer is not there as compared historically. The ongoing problems in their housing & labor markets has the end effect of them buying less. So intervening until there is change in the USD or consumer may hurt us, internationally also said relations with the US as they indicated recently in commentary that the low USD is beneficial, given low inflation.

    However I do notice rapid appreciation against other currencies, that have also risen against the USD, the USD has not hit a bottom so intervening against that repeatedly, is foolhardy heroism that a favorable US-Canada exchange rate could solve our problems, if we were to intervene the least damaging and albeit cautious is intervention to limit this excess appreciation against a basket of currencies.

    P.S
    Keith made good points also if were going to lower our currency the way investors react to government spending might turn some of the unnecessary leveraged investment away.

  • Well, if we want government programs and a weaker dollar, and for that matter somewhat higher inflation, how about printing some money?

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