Bank of Canada Governor Mark Carney has given his clearest warning yet that he will take steps to arrest the dollar's ascent if international investors continue to push it higher at the current pace.
At a news conference Thursday, Mr. Carney said the dollar's jump to above 95 U.S. cents in the last couple of weeks is impeding the recovery, putting in jeopardy policy makers' efforts to stoke inflation back to their target of an annual rate of about 2 per cent.
The inflation target, which the central bank is mandated to meet under the terms of its operating agreement with the finance department, is next to sacrosanct.
Mr. Carney said he has a range of tools and he can use to dampen the blow of the currency's rise, and signaled that any investor who thinks he's shy to use them is making a mistake.
"Markets should take seriously our determination to set policy to achieve the inflation target," Mr. Carney said. "Markets sometimes lose their focus. We don't lose our focus."
Mr. Carney spoke to reporters after releasing his latest quarterly report on the economy.
In the October Monetary Policy Report, the Bank of Canada said the dollar's jump above 95 U.S. cents in the last couple of weeks is mostly the result of investors seeking higher yields than can be found in the United States, comments that increase the odds of some kind of response by policy makers to counter the gain.
The central bank noted that the dollar traded in a range of 90 to 94 cents from July to early October, then "appreciated sharply" to an average of about 96 cents over the past 10 days.
"While higher commodity prices have been supportive, movements in the Canadian dollar over the period appear to have been increasingly driven by a broader depreciation of the U.S. dollar against most major currencies," the report said.
The distinction is important because the central bank is more tolerant of a higher currency that is the result of increases in the price of oil, natural gas and wheat, or more demand for Canadian goods, because more money is flowing into the economy.
When the currency appreciates largely as the result of speculative portfolio flows, the central bank believes the gain has a net negative effect on the economy because a stronger currency makes Canadian exports less competitive in global markets and companies earn less on sales of goods priced in U.S. dollars.
On Tuesday, the Bank of Canada left is benchmark lending rate at a record low of 0.25 per cent, saying the dollar's appreciation likely will "more than fully offset" favourable developments in the economy, such as surprising demand for houses and stronger consumer and business confidence.
In July, the central bank projected the loonie would trade at around 87 cents. Its revised assumption is that the currency will trade at around 96 cents for the next quarter.
Anything higher could further impede the recovery, which would delay policy makers' efforts to stoke inflation back to their target of 2 per cent.
Prices declined at an annual rate of 0.9 per cent in the third quarter, and the central bank doesn't expect prices to increase at a 2 per cent pace until the third quarter of 2011, which is three months later than estimated in July.
"A stronger-than-assumed Canadian dollar, driven by global portfolio movements out of U.S.-dollar assets, could act as a significant further drag on growth and put additional downward pressure on inflation," the Monetary Policy Report said.
Policy makers repeated that the central bank retains "considerable flexibility" to stoke the demand required to get inflation back to the 2 per cent target.
Even though Bank of Canada Governor Mark Carney has intimated since June that he is willing to intervene in foreign-exchange markets if necessary, few economists think the economic conditions warrant the central bank wading into global financial markets to buy securities such as U.S. Treasury bills in order to increase the supply of loonies, and thereby lowering the value.
The more likely response would be a decision to leave the benchmark overnight target near zero, which the central bank repeated this week that it is willing to do until at least June 2010, conditional on the outlook for inflation.
The fact that inflation is more muted than policy makers expected increases the odds that the policy makers will leave the benchmark rate unchanged, making Canada a less attractive bet for international investors relative to jurisdictions, such as Australia, that raise interest rates.
The exchange rate's effects on companies lag, and at the moment, the Canadian economy is still reaping some benefits from the Canadian dollar's decline during the worst of the crisis - a period when the U.S. currency rose as global investors sought protection in a legal tender that can be spent most anywhere in the world.
Policy makers said Canada's gross domestic product rose at an annual rate of 2 per cent in the third quarter, an increase from its previous estimate of 1.3 per cent. The Bank of Canada also revised its outlook for the current quarter, saying GDP likely expanded at a 3.3 per cent annual pace, compared with its July forecast of 3 per cent.
However, the central bank expects the economy to expand slower in 2010 and 2011 than it originally projected, as demand for houses recedes and the effects of the current appreciation of the currency are more clearly felt.
"Following three consecutive quarters of sharp contraction, economic growth has resumed in Canada," the report said. "Over the balance of the projection period, growth is slightly lower, reflecting the effect of the higher value of the Canadian dollar."