In its last FOMC meeting, the Federal Reserve noted that conditions "are likely to warrant exceptionally low levels for the federal funds rate for an extended period", and some Canadian observers interpreted this decision as a signal that the Bank of Canada would -- or should -- refrain from increasing rates in the near future.
I don't see why. The Bank of Canada and the Federal Reserve are facing different problems and will adopt different policies; that's the whole point about having an independent currency. Indeed, if there's one thing that we've learned from this latest crisis, it's that the case for a Canada-U.S. monetary union has been fatally weakened.
Let's think about what would have happened over the past few years if a monetary union had already been in place. Instead of generating an appreciation of the Canadian dollar, the commodity boom would have drawn in larger and destabilizing flows of investment. As it was, the appreciation of the Canadian dollar tempered the flow of capital, and kept inflation under control.
When the recession hit and commodity prices fell, our floating currency gave us a 20 per cent exchange rate depreciation in the space of five months. This sort of stimulus would have been unavailable under a monetary union -- as Spain is now finding out, to its great cost.
For reasons that Paul Krugman explains here, Canada has always been an interesting case study in international monetary policy. Canada's decision to adopt a floating exchange rate in 1950 -- several decades before the post-war Bretton Woods system of fixed exchange rates collapsed -- was an unorthodox reaction to a situation with which we've become familiar: sharply fluctuating commodity prices. As the Bank of Canada's Larry Shembri notes in the Spring 2008 issue of the Bank of Canada Review (pdf), fluctuating commodity prices had forced the Bank to change its exchange rate peg in 1946 and again in 1949. In 1950, the Bank simply gave up trying to predict the 'fundamental' exchange rate and decided to let the Canadian dollar float. Since then, commodity prices have not become less volatile, and we are no closer to figuring out what the exchange rate should be at any given time.
Monetary union is an extreme form of fixed exchange rates, and fixed exchange rates have only served us well during periods of relative stability. The recent recession was probably the last nail in the coffin of the proposal for a common Canada-U.S. currency.
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