I wrote a post a few months ago on the curiously nonlinear relationship between the Canadian exchange rate and oil prices. Since then, the prices of oil and other commodities have continued to increase, and it is perhaps time to consider the policy implications of the kink at parity.
And here is the story I told about it:
During the 2000's, oil prices drifted up and dragged the CAD with it along what looks to be a fairly straight line. By the time oil prices hit $US 80 in September 2007, the CAD was near parity with the USD. Oil prices continued to rise, and it looks as though the relationship that had held for six years remained stable for a couple of months more: the Canadian dollar continued to appreciate.
But here's where it gets weird. For some reason, the CAD depreciated back down to about USD 1.0 in November 2007, and it fluctuated around parity for the next eight months or so, even though oil prices almost doubled.
Since then, oil prices have continued to increase, but the Canadian dollar has stayed around parity:
The dash-dot line is a linear regression fitted through the blue data points, which are those where the price of oil is less than $85 US. Once again, the oil price-exchange rate relationship has broken down, just as oil prices hit the region that would predict a CAD significantly above parity.
You get a similar pattern if you use the Bank of Canada's commodity price index, but the difference here is that so far, we aren't in the region where commodity prices would predict a CAD well above parity with the USD:
Once again, the dash-dot line is a fitted linear regression using data points where the index is less than 620.
Exactly why we'd get such a non-linear relationship isn't immediately clear. The simplest and most plausible explanation I can think of is psychological: forex traders see parity as a powerful focal point, and are unwilling to adventure into price ranges we haven't seen in generations.
But that's not really the question that interests me here. If the prices of oil and of other commodities continue to increase, and if - for whatever reason - forex markets decide to set the exchange rate at parity, then what are the policy consequences of an under-valued Canadian dollar? It would seem to me as though one obvious consequence would be interest rates higher than they would otherwise have been.
There must be others. In the months in which oil prices were rising and in which the CAD was not appreciating, oil exporters were fabulously profitable, and investment flows were probably too large to be absorbed by the existing infrastructure. If - or when - that happens again, what should be the policy response?
Any ideas for what the policy challenges - and solutions - might be for an under-valued Canadian dollar?