Bank of Canada Governor Mark Carney has a problem: Many investors are having a hard time believing that he would actually tailor monetary policy to slow the loonie's ascent.
Mr. Carney went out of his way early last month to signal displeasure with the dollar's record surge in May, an unusually aggressive stand for a central banker who prefers to remain silent about the decisions of private investors.
In the Bank of Canada's last policy statement, and then in public appearances that followed, Mr. Carney warned that the "unprecedentedly rapid rise" of the dollar risked snuffing out early signs of an economic recovery.
Beginning Tuesday with the release of the central bank's latest policy statement, and again on Thursday when policy makers publish their latest quarterly report on the economy, Mr. Carney will have the opportunity to convince skeptical traders of his intentions.
Perception is key.
If the traders making a speculative play on the dollar fear the central bank could push back, they will be less likely to bid up the value of the loonie against the U.S. greenback. If those traders decide warnings from the central bank are just so much talk, they will proceed with their bet on the dollar and make life difficult for Canadian exporters.
The Canadian dollar's roller-coaster ride this year is already a headache for exporters.
Exporters are fighting over scant orders amid the biggest collapse in world trade since the Second World War. The more they struggle, the more difficult it becomes for policy makers to generate the economic growth they need to get the annual inflation rate back to their target of 2 per cent.
Mr. Carney's tough talk last month appeared to work at first.
The dollar tumbled back to earth over the remainder of June and into July. But last week, the loonie suddenly found new life, jumping 4.6 per cent, a reminder of how difficult it is to tether a currency that has become linked to commodity prices and has become a favourite of hedge funds and others who profit by speculating in foreign exchange markets.
The state of the U.S. remains the biggest worry for the Bank of Canada. The halting recovery of the world's largest economy and Canada's biggest trading partner ensures that the central bank will conclude its latest round of policy meetings this morning with a decision to recommit to its plan to leave the benchmark interest rate at a record low of 0.25 per cent until the middle of 2010.
But if the U.S. is the biggest concern, then the volatility of the currency is Mr. Carney's biggest frustration.
Deflation is no longer a serious threat, as the central bank's quarterly survey of business managers showed last week that 84 per cent expected prices to increase at an annual rate of between 1 and 3 per cent over the next two years.
For the first time in 43 cash auctions dating back to September, the Bank of Canada didn't release all the funds on offer July 13, a signal that credit markets are getting stronger.
And consumer confidence appears to be holding up even as unemployment rates rise. Sales of existing homes rose 8.7 per cent in June, the fifth consecutive monthly increase, the Canadian Real Estate Association reported last week.
That leaves the currency.
Canada's economic growth won't return to steady annual increases of about 3 per cent that were the norm in the years before the crisis without a boost from trade. The Bank of Canada said in April that the collapse of global trade would subtract 4.6 percentage points from gross domestic product this year, by far the biggest blow to the economy. By comparison, trade contributed 1.3 points to GDP in 2005.
Mr. Carney is going against his instincts to even comment on the currency. The former investment banker has refrained from discussing the dollar in any significant way since taking over as Governor in February, 2008, a contrast with his predecessor, David Dodge, who was more willing to engage on the topic.
Last month's warning came after the loonie soared above 91 U.S. cents. Canada's dollar closed at 90.30 cents Monday, extending this month's gain to about 5 per cent, the best performance of the 16 most active currencies tracked by Bloomberg.
Yet the tenor of the discussion in financial markets is that Mr. Carney is merely sabre-rattling. Citing what he called the Bank of Canada's "near-religious adherence to maintaining a free-floating currency," Stewart Hall, an economist at HSBC Securities in Toronto, told his clients last week that intervention is "unlikely."
Working against Mr. Carney is the Bank of Canada's history as one of the strongest proponents of allowing exchange rates to float in open markets.
In 1950, Canada became the first country to break with the Bretton Woods system of fixed exchange rates that followed the Second World War. The central bank officially abandoned systematic forays into the currency market in September, 1998, declaring that future interventions would be discretionary and occur only in exceptional circumstances.
Still, the view that Mr. Carney won't stand in front of the dollar's rise might be too sanguine. The financial crisis is forcing policy makers to deploy weapons they would rather keep locked in the ammunition cabinet.
Fearful of deflation, the Swiss National Bank has been buying international currencies to weaken the franc since March. Before this year, Switzerland's central bank - which is set to be taken over by Mr. Carney's former Oxford University classmate Philipp Hildebrand, the current vice-chairman of the governing board - hadn't intervened since 1995.
While the Bank of Canada is forthright about its doubts that it can alter the currency's value, it is less clear on whether it thinks it can smooth the volatility of foreign exchange markets, something both the Reserve Bank of Australia and Reserve Bank of New Zealand explicitly say they are willing to attempt.
The dollars of Australia and New Zealand, which like the loonie tend to rise and fall with risk appetite and commodity prices, gained 1.2 and 1.6 per cent, respectively, this month.
Canadian policy makers are in a unique position to try the approach of their antipodean counterparts. They have spent months studying ways to lower borrowing rates by creating money to purchase financial assets. The strategy, called quantitative easing, could also make the currency less attractive to speculators by increasing the supply of dollars.
Douglas Peters, a junior finance minister in Jean Chrétien's Liberal government, said Mr. Carney should try it.
Mr. Peters, who is also a former chief economist at Toronto-Dominion Bank, said the dollar's bursts and busts are tied to "huge speculation" linked to the prices of commodities, especially oil. To better link the value of the currency to the economic fundamentals, the central bank should be more aggressive about trying to take some of that speculative froth out of the market, Mr. Peters said.
"I think they could do a little more," Mr. Peters said from Toronto. "It could be useful to smooth out some of these wild fluctuations."