Economists warn rate cut could erode confidence in loonie

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A potential rate cut by the Bank of Canada this week risks undermining confidence in the Canadian dollar, some prominent Canadian economists have warned.

Never before has the loonie fallen so far, so fast, against the U.S. dollar as over the past two years.

"Currency instability has become a concern, and we think the Bank of Canada must take note," National Bank Financial chief economist Stéfane Marion said in a report on Monday.

"In our view, the Bank of Canada would be better to keep its powder dry this month and act, if need be, after the next federal budget when it will be better able to assess fiscal support to the economy."

Trading in overnight index swaps currently implies the probability of a rate cut at about 60 per cent when the Bank of Canada releases its monetary policy report on Wednesday.

Economists calling for the key overnight lending rate to be maintained at 0.50 per cent say additional stimulus could test consumer sentiment. A cut to 0.25 per cent as expected by the market could bring about a "runaway exchange rate," said Avery Shenfeld, chief economist at CIBC World Markets.

"The unprecedented pace of its decline risks an even larger hit to growth by shocking household confidence," Mr. Shenfeld said in his weekly economic commentary on Friday.

He noted that the exchange rate serves as a barometer of the economy for many Canadians.

With the cost of travelling to the U.S. suddenly prohibitive to many, and the price of cauliflower a national talking point, the currency's withered stature is very much on the mind of the average Canadian consumer.

Over the past two years, the Canadian dollar has lost a full 25 cents in value – a downward slope unmatched in steepness, Mr. Marion said.

Certainly, a great deal of downside is to be expected considering Canada's current economic circumstances. Prices for crude oil and other resources such as copper are sinking to multi-year lows and domestic economic growth appears to be stagnating. Meanwhile, the U.S. dollar has been gaining considerable strength against major currencies worldwide.

But the losses should have been more like 10 cents, not 25 cents, Mr. Marion said. "Is the loonie out of whack with its fundamentals? We think so."

While there are benefits to households, most notably through lower energy prices, the rising costs of imports are also passed through to consumers, who are finding some fruits and vegetables far more expensive these days. The effect is "fast eroding standards of living," Mr. Marion said.

Another rate cut could erode consumer sentiment, both through additional currency depreciation and for the economic adversity a rate cut telegraphs, said George Davis, chief technical analyst at RBC Dominion Securities.

"Anecdotally, we're already seeing some signs of erosion in consumer confidence."

On the corporate side, a depreciated currency helps the beleaguered energy sector by making exports more attractively priced, all else being equal.

A further rate cut is needed to keep the dollar low, maintaining that cushion, veteran Canadian economist Ted Carmichael said in a blog post.

He sits on C.D. Howe Institute's monetary policy council, which called for the Bank of Canada to hold rates as they are. There are four chief economists of Canadian chartered banks on the council, all of which advised against a cut.

Mr. Carmichael's dissent said currency fears are overblown, and the idea that the loonie has fallen too far fails to grasp the magnitude of the commodity correction.

"I don't think many people recognize that Canada's commodity terms of trade in January, 2016, are 28 per cent weaker than they were at the lowest point of the Great Recession of 2008-09," he said.