Prices for retail goods in Canada remain stubbornly high, despite the Canadian dollar rising substantially since 2002. Normally this should lead to falling prices, as a higher Canadian dollar lowers the (Canadian dollar) price of foreign goods. This is not happening. A decade ago, a product that cost $1 (U.S.) in the United States cost, on average, $1.20 (Canadian) in Canada. A decade later, there has been little change.
Many fingers have been pointed at Canada’s retail community for failing to lower prices. The real culprit, however, is the Bank of Canada, which is purposely preventing these price reductions. Despite keeping prices high, the central bank is fully justified in its actions, and Canada is still benefiting from the higher dollar.
The central banks of both the United States and Canada have maintained an (approximate) 2-per-cent inflation standard as a key determinant in setting interest rate policy, with inflation defined by an increase in the Consumer Price Index. Because of this, consumer prices must rise by roughly two per cent per year in both countries. This (exchange-rate-unadjusted) $1 (U.S.) to $1.20 (Canadian) price ratio must be maintained if both countries maintain these inflation policies, despite the economic pressures that should be lowering consumer prices in Canada.
Since, thanks to the high Canadian dollar, there are downward pressures on prices, the Bank of Canada is forced, by its inflation-targeting mandate, to counteract this by expanding the money supply faster than the United States. This added money prevents prices from falling and puts inflation back to the mandated 2-per-cent level. Despite similar levels of inflation, this faster money supply growth will lead to lower interest rates in Canada, since there is more money available for lending. Lower interest rates lead to enhanced investment and economic activity. This is best illustrated by the Canadian data for real hourly wages, which have increased substantially since 2002.
Over time, the faster money supply growth leads not only to lower interest rates, but puts downward pressure on the Canadian dollar. Over time, this pressure should cause the exchange rate to return to a level that reflects the relative prices between the two countries. In theory, the Bank of Canada could escalate this process by increasing the money supply at an even faster rate, but in so doing the rate of inflation would increase well beyond the bank’s 2-per-cent mandate.
The stronger Canadian dollar is an unqualified benefit to our economy, even if it is not directly leading to lower consumer prices. Thanks to the Bank of Canada’s mandate, we are not seeing the benefit through prices, but rather through reduced borrowing costs and higher real wages.
Mike Moffatt is an assistant professor in the Business, Economics and Public Policy group at the Richard Ivey School of Business, University of Western Ontario.