About a year ago, The Globe and Mail columnist David Parkinson echoed one of our research papers in which we expressed our concerns about the sustainability of Canadian dollar parity. Our thinking at that time was along these lines: The Canadian economy should underperform the U.S. economy down the road; the Canadian real estate market is cooling; the bull market in commodities is about to fade; and, last but not least, Canada's competitive position is in bad shape with the Canadian dollar at such an elevated level. As a result, we anticipated the loonie would fall from parity to a level of 90 to 92 cents (U.S.),within 18 to 24 months.
It seems that our argument about Canada's competitiveness found some echoes within the walls of the Bank of Canada, as new Governor Stephen Poloz is barely hiding the central bank's intention of pushing the dollar down toward its fair value – commonly called its purchasing power parity (PPP) level.
What we find most interesting about this story is not only the speed at which the dollar has fallen since late October, but how the Bank of Canada was able to achieve such impressive results without even touching its main policy tool, the overnight rate.
Shift in drive: from commodities prices to the Canada-U.S. rate spread
The bulk of the loonie's fall from parity during 2013 and to the current 90-cent level was not caused by market forces alone, as we had foreseen, but rather by a radical shift in the Bank of Canada's monetary policy language. The first step was removing the "tightening bias" from the monetary policy statement last October; the second step was stating in January that rates could go up or down, depending on many factors, including the possibility that the country might be entering a phase of deflation.
This has all been nothing but talk. The central bank has not in fact done anything, other than revise its guidance. This goes to show that "talking down the dollar" can give some spectacular results.
The impact of changing monetary policy guidance can best be seen by looking at the relationship between the Canadian dollar and the interest rate differential between Canada and the United States. Neither the Bank of Canada nor the Federal Reserve have changed their overnight rates in the past year, but the differential in medium-term rates (five-year rates, for example; see Chart 1) has fallen sharply since the bank changed its tune in late October, and is now right around zero. If the trend continues, we can safely assume that this differential could move deep into negative territory in 2014, putting further downward pressure on the loonie.
The past few months' action suggests that the relationship between the Canadian dollar and commodities prices might be broken for the time being, and that this could last for quite a while – at least as long as the Bank of Canada keeps its current guidance intact.
Loonie headed to long-term PPP equilibrium of 85 to 86 cents?
With Canada being plagued by a current account deficit, the loonie could trade temporarily above its PPP value only if two factors are present: positive Canada-U.S. interest rate spreads or a sustainable bull market in commodities (chiefly oil and gas). And just as we expressed a year ago, we don't expect either of these factors to be in play in the coming years.
The dollar, in fact, does not frequently trade at or close to its long-term PPP equilibrium value (see Chart 2). In the past 30 years, the dollar has traded significantly above or below PPP levels for spells of as long as 10 years.
Looking at the past 10 years, during which commodities prices were rising and Canada's interest rate differential was mostly positive (i.e. Canadian interest rates were above those of the U.S.), the loonie has been trading almost exclusively above PPP levels. But now, these factors have changed, and are combining to bring the dollar back down toward or even below PPP levels within the next year or two. We have recently revised our December, 2014, target for the dollar to a range of 86 to 88 cents, just above the PPP level.
All in all, we believe this is good work by the Bank of Canada. A devaluation of the dollar was needed to give a spark to our country's eroding competitiveness, and this manoeuvring was impressively done without lowering the overnight rate – thereby not creating more incentive for today's highly indebted Canadian households to keep buying on credit. And for Canada in general, a softer currency will make it easier to reach the objective of transitioning from a consumption-driven economy to one led by investments and exports.
Clément Gignac is senior vice-president and chief economist at Industrial Alliance Insurance and Financial Services Inc., vice-chairman of the World Economic Forum Council on Competitiveness and a former cabinet minister in the Quebec government.