The Canadian dollar complicates the Bank of Canada’s fight against inflation

Lagging Canadian Dollar Makes Bank of Canada’s Inflation Fight Even More Difficult

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If battling decades-high inflation wasn’t tough enough, the Bank of Canada now faces the added burden posed by a struggling loonie, which has plunged in recent weeks.

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The Canadian dollar fell to a two-year low below 73 cents US at the end of September. Although it has been back above the 73 cent mark in recent days, the decline from the 77 cent range it was trading in at the start of last month could add to the country’s inflation problems by effecting imports, especially those from the United States. , Canada’s most important trading partner — more expensive.

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« I think there have been times when the inflationary impact of the loonie has made life difficult for the Bank of Canada, » said Benjamin Tal, deputy chief economist at CIBC Capital Markets.

Tal added that given the unusual dynamics of the current downturn, the central bank « may need to keep interest rates higher for longer than expected » in the face of these additional inflationary pressures.

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In a normal economic downturn, rising interest rates would slow down the consumer. However, Tal noted that the recent downturn has been unique in that the labor market has remained robust – supporting wage growth for lower income brackets – while the substantial savings accumulated during the pandemic give the consumer the power to purchase to continue spending in the face of rising prices. .

Governor of the Bank of Canada, Tiff Macklem.
Governor of the Bank of Canada, Tiff Macklem. Photo by Justin Tang/Bloomberg

Tal does not expect these factors to translate into higher inflation in the next data release, as the cooling in commodity prices is moving in the opposite direction and has already brought inflation back below the bar. 8%. However, he said he believes the lagging loonie will affect how quickly the Bank of Canada can bring inflation back to its 2% target.

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Bank of Canada Governor Tiff Macklem acknowledged that the loonie was proving troublesome, telling an audience in Halifax on Oct. 6 that the weaker exchange rate is at least offsetting some of the disinflationary effects of lower commodity prices and smoother supply chains.

« We cannot rely on an easing of pressure on global prices to reduce inflation in Canada, » Macklem said in prepared remarks posted on the central bank’s website. “At a minimum, improving global factors will take time to feed through to Canadian inflation. And the recent depreciation of the Canadian dollar against the strength of the US dollar will offset some of this global improvement by making US goods and vacations more expensive for Canadians.

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Normally, the Canadian dollar would have risen with commodity prices, as it tends to follow the price of oil. But that didn’t happen this summer. In July, Macklem said that because the country was not seeing the loonie’s appreciation tied to commodities as expected, the central bank should push harder on interest rates.

When oil broke above US$100 this year, the loonie did not soar in tandem, barely touching the US80 cent level. Macklem pointed to the absence of major investments in oil projects that have dampened demand for Canadian dollars as one of the reasons this connection has come loose.

The inflationary impact of the loonie complicates the life of the Bank of Canada

Benjamin Tal, Deputy Chief Economist, CIBC Capital Markets

Today, with falling oil prices and the US Federal Reserve’s hawkish policy causing many to predict that US rates will eventually rise more than Canada’s, the loonie is actually falling, which is exerting more pressure on interest rate policy here.

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Canada is not alone in its monetary struggles. The Fed’s aggressiveness pushed the greenback higher against currencies around the world. The Canadian dollar has actually fared better against the greenback than its G7 counterparts, but Canada’s reliance on the United States as a trading partner amplifies the impact on our economy.

The magnitude of the currency impact has been debated.

Over the past few decades, a 10% drop in the Canadian dollar has resulted in a short-lived 0.5% upside shock to annualized headline inflation, according to Karl Schamotta, chief market strategist at Cambridge. Global Payments.

“It can take six to 12 months for the currency effects to show up, if they happen,” Schamotta said.

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But Schamotta added that these impacts are small and may surprise observers.

Indeed, certain factors at play could reduce the sensitivity of the economy to exchange rates. On the one hand, the cost burden in supply chains rests heavily on domestic services (such as marketing and logistics), which are generally less sensitive to changes in exchange rates.

We don’t see the Canadian dollar improving until later in 2023

Benjamin Tal

Falling commodity prices, dollar hedges already in place by importers, and the nature of exchange rate depreciation – which is usually associated with lower aggregate demand making it harder for businesses to increase prices – all work in tandem to reduce exchange rate sensitivity.

Schamotta said exchange rate-induced inflationary pressures are usually short-lived and central banks would avoid an overreaction and impulsive reaction.

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The Fed's aggressiveness pushed the US dollar higher against currencies around the world.
The Fed’s aggressiveness pushed the US dollar higher against currencies around the world. Photo by Dado Ruvic/Illustration Reuters

« Although academics have tried to identify one for decades, no one has ever identified a fundamental equilibrium exchange rate that the central bank can target, » Schamotta said. « The best policymakers can do is adjust interest rates to reflect domestic supply and demand fundamentals, and let the currency act as a balancing mechanism. »

Unless there is clear evidence of significant loonie-led inflation, Schamotta said the Bank of Canada is unlikely to adjust policy settings or try to talk foreign exchange markets.

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A weaker loonie should stick with Canadians for a while longer. Bank of Montreal senior economist Sal Guatieri said in an Oct. 5 note that the loonie is likely to depreciate further this year, due to interest rate differentials between Canada and the United States.

Tal echoed that sentiment, noting that an unbalanced market will keep the loonie lower for longer.

« We don’t see the Canadian dollar improving until later in 2023, when interest rates stop rising and the market essentially enters some kind of equilibrium, and to the extent that the flow of safe-haven to the United States will be reversed, » Tal said. “But in between, we will have a situation where the Canadian dollar will remain under pressure.”

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