John Woods
The recent appreciation of the Canadian dollar has prompted calls for the Bank of Canada to intervene. The clamouring is motivated by the sentiment that a higher exchange rate is putting an unwarranted damper on economic growth and might push inflation below the target 2-per-cent inflation rate. In this story, a rising currency should be countered with lower interest rates from the Bank of Canada.
Whether the Bank of Canada should respond to currency fluctuations depends on why the dollar is moving. Are the reasons related to economic fundamentals (in which case the currency fluctuation is a self-correcting mechanism)? Or are they due to a collective mental spasm in financial markets (in which case intervention would be warranted)?
Consider three changes in economic fundamentals for which the currency acts as a self-correcting mechanism: terms of trade, perceptions of future investment returns and political risk.
On the first, Canada's terms of trade are, among other things, correlated with movements in commodity prices. As commodity prices rise, our relatively large commodity sector will strengthen and push up growth and inflation. A stronger dollar is a natural offset to rising commodity prices as a rising dollar dampens excessive growth that would lead to inflation. In this case, if the government reacted to a rising currency with lower interest rates, it would just result in excessive growth and an overshoot of our inflation targets.
On the second, perceptions of future investment returns on a country-to-country basis are often affected by large shifts in fiscal policy. Bad fiscal policy - in the form of unsustainable deficits and debts - will cause investors to expect increases in future taxes and lower rates of return. In that case, the relative attractiveness of that country as a place to work and invest will fall, driving down economic growth. In response to poor fiscal policy, a falling currency can provide the automatic stabilizer to lower growth rates resulting from rising deficits and unsustainable debts.
And this is exactly the picture we are seeing south of the border. Barack Obama has put the United States on a debt and deficit path that is far worse than Canada experienced in the early 1990s, when The Wall Street Journal called Canada an "honorary member of the Third World" and our dollar was flirting with historic lows.
In that light, is it any wonder that the loonie has risen relative to the U.S. dollar? Canadian deficits are projected to be a fraction of U.S. deficits, and our debt levels are the envy of the world. An appreciation of the Canadian dollar is a damper on these improvements in our economic outlook that are making Canada a relatively attractive place to invest and work. Again, responding to this rise in the dollar with lower interest rates would be a mistake.
The third, political risk, is a bit more ephemeral. For Canada, the sovereignty movement has generally been seen as a risk that would drive down Canada's attractiveness as a place to work and invest. Any political instability from a sovereignty crisis would push economic growth downward. To the extent that this risk was offset by a falling exchange rate, this impact would be buffered.
On this front, too, Canada is doing well. The sovereignty movement would appear to be enjoying its worst period of public support in decades. This reduction in political risk should, other things being equal, result in a higher Canadian dollar as investors lower their risk profile of Canada.
It is conceivable that economic fundamentals are not behind the currency appreciation. For that to be true, however, you must believe that markets are exhibiting a collective mental spasm completely unrelated to economic fundamentals. You have to believe that those traders and their money are blind to the economic realities of rising commodity prices, Canada's relatively strong fiscal position and the decline of Quebec sovereignty.
But that would be a rather gloomy way of looking at Canada. I'd prefer to think our rising dollar reflects the fact that Canada's economic fundamentals are relatively strong, and that the rising dollar is a sign of our economic strength and wealth relative to the rest of the world.
So back off, Bank of Canada. Our currency is fundamentally fine.
Ken Boessenkool is a research fellow at the School of Public Policy at the University of Calgary.