Gary Rabbior is the president of the Canadian Foundation for Economic Education. This is the last of a six-part series on understanding how the economy works and why it matters to investors.
To understand why investors should care about how Canada’s money is managed, there are a number of key things to note.
One, if there are signs of inflation growing in our economy, then investors should be aware that is it likely that interest rates will start to rise. This will happen for two reasons. First, lenders will want to start protecting themselves against the erosive effects of inflation – so they will start to add an “inflation premium” to interest rates.
Second, if the Bank of Canada appears concerned about the rising rate of inflation, then it will start to try and push interest rates up to dampen spending, borrowing, and demand to try and cool off the inflationary pressures.
So, if it looks like there may be “too much money and too much spending” ahead, investors should consider possible higher interest rates in their decisions.
Consider the current situation. Interest rates are at virtually a historic low. There has been unprecedented government stimulus spending to try and boost the economy. As the economy recovers, and with all that government spending in the system, there is a possibility that spending may overheat the economy. Managing the reduction and removal of the stimulus spending will be difficult for governments and, if it is not managed well, rising inflation could be unleashed. With signs of that – and with signs of a recovering economy – the Bank of Canada may start to move rates higher to try and keep a lid on the increases in spending, borrowing, and demand in the economy. Conclusion – within the year, interest rates should start to rise. How fast and how high they may rise will depend on the rate of increase in spending and prices in the economy.
An Investor's Guide to Understanding the Economy:
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If there are signs of a sagging economy, then one can look to a decrease in interest rates – or for low interest rates to stay low. For example, some people talk about how fragile the current recovery is. There is talk of a possible “double-dip” recession – that is, some recovery and then another turn down. But if events did unfold that indicated that the economy may take a turn down, then one could assume that interest rates will continue to stay low for some time.
If the value of the Canadian dollar should rise to where the Bank of Canada is expressing concern, this is a sign that the demand for Canadians dollars – to buy our exports, to invest in Canada, to speculate on the value of the Canadian dollar, etc. – is high relative to the supply. The Bank can try and increase the supply of Canadian dollars by buying up foreign currencies with Canadian dollars. It could also try and reduce the demand for our dollar – perhaps by lowering interest rates. But that would be hard for the Bank to do at this time due to how low interest rates are.
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Understanding the Canadian dollar: A four-part series
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If the value of the dollar should start to fall to where the Bank gets concerned, then the Bank may take actions to try and boost its value. Why would the Bank be concerned about a low valued dollar? One reason might be because it would push up the cost of imports to Canadians which can help fuel inflation. A falling dollar would be a sign that the demand for the dollar in exchange markets is relatively low compared with the supply. To boost the value of the dollar, the Bank may try and reduce the supply (e.g. using reserves to buy up Canadian dollars) or it could raise interest rates to attract foreign investment looking for a higher return – or speculating that the dollar`s value is going to rise because of actions by the Bank of Canada.
