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High-flying loonie can't hold rate rise back

Bank of Canada Governor Mark Carney is expected to leave rates unchanged at the Bank of Canada's February meeting.

Sean Kilpatrick/Sean Kilpatrick/The Canadian Press

For now, the strong dollar is giving the Bank of Canada one more reason to keep interest rates on hold. But that cushion can't last forever, the bank suggests in its latest quarterly forecast.

The central bank's projections, released Wednesday, include an assumption that the loonie could trade above parity for years, and also reinforce the notion that interest rates will rise, even though that could boost the currency still higher.

The strength of the loonie is causing Canada's economic performance to boomerang, with a growth spurt at the end of 2010 and the beginning of this year giving way to a slower pace that could persist beyond 2013, restraining exports, the central bank said Wednesday.

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However, although the bank strongly suggested that the risk of "greater headwinds" from the loonie gives policy makers more time before inflation becomes an issue, it also said the slack in the economy is disappearing more quickly than expected. Its projections incorporate a "gradual reduction" in monetary stimulus.

In other words, the currency's effect on foreign sales of Canadian products is a long-term challenge that cannot delay higher borrowing costs forever.

"Persistent strength in the Canadian dollar is an important headwind to growth and inflation in Canada," Governor Mark Carney told reporters Wednesday at a press conference in Ottawa. "All that said, we're going to manage monetary policy in order to achieve the inflation target." Indeed, the central bank listed as one of the "assumptions" behind its forecast a Canadian dollar trading at an average level of $1.03 (U.S.). While that is not a prediction per se, it is factored into the bank's forecasts for economic growth and inflation.

Wednesday's report also assumes that oil will trade above $100 (U.S.) a barrel throughout the bank's projection period - and at $109 (U.S.) for three quarters starting with the second half of this year - plus "persistently strong" prices for non-energy commodities. This all fuels the loonie since Canada is a key producing nation.

All told, that means that while the central bank sees faster Canadian growth this year than it did in January - upping its 2011 projection to 2.9 per cent from 2.4 per cent - much of that increase is explained by a 4.2-per-cent expansion from January through March, on an annual basis. The current quarter will see a significant slowdown to a 2-per-cent pace of growth, with evidence that exports have already started to take a hit. Growth will then pick up, while remaining below 3 per cent, and gradually slipping to just above 2 per cent by the end of 2012.

While acknowledging that the currency means an extremely challenging competitive landscape for Canadian exporters and that this could get even tougher in the coming years, Mr. Carney again urged executives to seize the moment to forge ahead with steps needed to ensure their survival in the post-downturn global economy.

Companies need to invest more aggressively than they have, taking advantage of the strong currency to buy new machinery and equipment overseas that can help them improve their productivity, he said, noting that such investment has recovered to about 55 per cent of its pre-recession levels, compared with closer to 90 per cent in the United States.

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"Investment has picked up smartly, but there is a ways to go," he said.

Mr. Carney has been sounding such themes for more than a year, admonishing corporate Canada for some executives' reluctance to invest to make themselves more efficient and productive, or to plunge deeper into the rapidly growing emerging-market economies.

Businesses, meanwhile, counter that the strong currency increases their costs and makes it more difficult to think - let alone act - ambitiously. Jay Myers, president and chief executive officer of Canadian Manufacturers & Exporters, said in an interview that the loonie's recent flight caught many executives by surprise even though they had learned to adapt in recent years to a higher currency.

"I don't think most executives had factored in a dollar at $1.04 (U.S.) or $1.05, or higher," Mr. Myers said. "The fact of the matter is, if you've got a high dollar here and high cost of doing business, that means the cash flow performance on the part of exporters is not as strong in Canada as it is in the United States, and therefore the rate of investment is not as strong." Mr. Myers worries the loonie could soar further if investors start to seriously question Washington's ability to deal with its staggering debt, which in turn depresses the greenback.

That could still be several years away, but the currency has clearly become a central problem for the central bank.

"The loonie's flight plan now appears to be even more of a critical factor affecting the future timing and magnitude of policy rate hikes," said BMO Nesbitt Burns economist Michael Gregory, "but it won't prevent them.''

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