The Canadian dollar's renewed flirtation with parity has caused plenty of navel-gazing among currency watchers and policy wonks. Among the more prevalent musings is whether the Bank of Canada should be taking into account the impact its interest rate decisions will have on a currency that may already be overvalued and slow down its rate hikes accordingly.
Well, rest easy, central bankers. The C.D. Howe Institute has looked under the hood of the Canadian dollar and found that its various moving parts have the currency humming just about where it should be.
Modelling The Fundamentals Policy analysts Philippe Bergevin and Colin Busby revisited the simple Canada/U.S. exchange rate model the Bank of Canada devised in the early 1990s, which used commodity prices and short-term interest rate differentials to explain movements in the loonie. While the model has been remarkably reliable given its simplicity, the two analysts fine-tuned it to see if a slightly more detailed set of fundamental factors could justify the currency's behaviour.
They found that while higher non-energy commodity prices have always been bullish for the dollar, higher energy prices have shifted from being bearish a few decades ago (when Canada was a net energy importer) to bullish now (as Canada has become a major energy exporter). So, they separated out the energy and non-energy elements for each of the past four decades, adjusting the model's expectations for each decade based on the trade flows of those commodity segments at the time.
Mr. Busby and Mr. Bergevin's also added a financial stress component - using the International Monetary Fund's Financial Stress Index - to recognize the tendency for investors to flock to the U.S. dollar in times of heightened financial risk, a previously overlooked factor that has come to the forefront over the past couple of years.
By examining what this "modified" Bank of Canada exchange rate model would predict for the Canada/U.S. exchange rate over the past four decades, the analysts found that, with a few exceptions, the Canadian dollar has traded at a price fairly close to where these underlying fundamentals suggest it should. And, they say, that remains the case today.
Rate Hikes Overrated Further, Mr. Busby and Mr. Bergevin's analysis indicates that the biggest influence on the loonie is not interest rate differentials, but commodity prices. In fact, they say, a one-percentage-point widening of the Bank of Canada's policy rate over that of the U.S. Federal Reserve Board would only pressure the loonie up by about 0.7 per cent.
This suggests that even a fairly active Bank of Canada over the next year would put only modest upward pressure on the currency - and even that could potentially be offset by heightened financial stresses stemming from sovereign debt fears.