Bank of Canada targets exporters with interest rate timing

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The Bank of Canada has just kicked the likely timing of an interest-rate hike further down the road, and the disappointing export sector was squarely in its sights as it did so.

Therefore it is fitting, perhaps even to some degree intentional, that the key beneficiaries of the notably dovish shift in the central bank's tone will be exporters. The bank may have just handed them a softer Canadian dollar.

In its rate announcement on Wednesday, the central bank once again (as expected) held its key rate at 0.5 per cent, where it has sat for the past 14 months. But in doing so, it spilled considerable ink on just how disappointing the export data have been over the past several months (July's strong rebound notwithstanding), and how they have undermined the economy's trajectory. Crucially, the bank's rate statement said, "the ground lost over previous months raises the possibility that the profile for economic activity will be somewhat lower than anticipated" in July's quarterly economic projections.

What this delicate choice of words is getting at, pretty clearly, is the output gap – the difference between what the economy is actually producing and what it has the capacity to produce. The closing of this gap is crucial to determining when the bank will begin to raise interest rates, because capacity constraints fuel inflationary pressures, and inflation stability is the Bank of Canada's focal point in setting rate policy.

What the bank is implying, in this slightly euphemistic way, is that the output gap may be wider than the central bank had expected it to be by now. In case the implication was not clear enough, it added that "risks to the profile for inflation have tilted somewhat to the downside since July."

The bank provided reason, too, why we should not count on some sort of rebound in exports as temporary factors that may have slowed them dissipate, making up for lost time and getting output back on track. "Exports disappointed even after accounting for weaker business and residential investment in the United States, adjustments in the resource sector, and cutbacks in auto production," the rate statement said. In other words, exports have been lousy even if we exclude the degree of lousiness caused by these factors.

As recently as its mid-July Monetary Policy Report, the Bank of Canada projected that the output gap would close in late 2017. But the lost quarter for exports suggests that even if everything gets back on track from here, it may be at least the first quarter of 2018 before the gap closes and the Bank of Canada is ready to raise rates. (Indeed, the bank's statement persuaded many market participants that a rate cut is now a distinct possibility; by Wednesday afternoon, the bond market was pricing in a 22-per-cent likelihood of a cut by early next year, up from 16 per cent a day earlier.)

The currency market's response to all this was predictable. The Canadian dollar quickly shed nearly half a cent against its U.S. counterpart after the rate announcement.

Canadian Imperial Bank of Commerce chief economist Avery Shenfeld, for one, suggested this may have been exactly what the central bank intended – to put downward pressure on the dollar. While the Bank of Canada is consistently adamant that it does not target exchange rates with its policy, there is little question that it would have foreseen such a reaction – and that it would have seen the potential to help lift the export sector out of its recent rut.

Despite Canada's economic struggles this year, the Canadian dollar has held stubbornly between 76 and 78 cents (U.S.) since the spring – a level that, many experts are increasingly convinced, is not low enough to give exporters the competitive advantage they need to sustain the kind of growth the Bank of Canada has been counting on. A key reason has been the repeated setback in the anticipated timing of rate increases in the United States, where the disappointing and uncertain pace of growth has probably delayed a hike by the Federal Reserve until the final quarter of the year. The delays have cooled currency traders' enthusiasm for the U.S. dollar, which has helped prop up the Canadian dollar's relative value, even as Canada's own economic health has not justified the strength.

With expectations of Fed hikes falling further after last Friday's tepid U.S. employment report and Monday's weak services-sector index from the Institute for Supply Management, it was certainly time to remind the currency market that Canada's outlook has suffered its own delays. The Bank of Canada's rate statement did just that.

Whether the bank intended to sway the currency is largely academic. It understood that this would be a consequence of its dovish rate statement. And it is a consequence that may address the bank's current biggest concern well.