Is the Bank of Canada bluffing?

From today's interest rate announcement:

Persistent strength in the Canadian dollar remains a risk to growth and to the return of inflation to target. In its conduct of monetary policy at low interest rates, the Bank retains considerable flexibility, consistent with the framework outlined in the April MPR.

The Bank has been issuing warnings such as these at regular intervals over the past few months. The forex markets then back off, the CAD starts back up again, and another warning is issued.

There's no question that the Bank of Canada is able to force a depreciation of the CAD if to chooses to do so. So the question is whether or not the Bank will actually intervene in forex markets for the first time since 1998.

Forex traders who view the CAD as an oil play might look at this graph:

and they might decide that since the CAD is trading in its usual range, there's no reason to think that the Bank will intervene. But that only makes sense if the Bank of Canada also viewed the CAD as an oil play.

Here is the same graph with the Bank's broader commodity price index:

Since my post at the end of July, the CAD has been bouncing around several points above the usual range of variation.

And there are a couple of other considerations:

1. Up until the crash in commodity prices, Canada ran a current account surplus, so an appreciating currency made sense. But now that we're running a current account deficit, it doesn't.
2. The last time the CAD hit parity with the USD, we saw a sharp drop in consumer prices; even the most arithmetically-challenged Canadian consumers revolted when they could see that they were paying higher prices than were being charged in the US. Consumer prices are already below the path that the Bank would like to see.

If we weren't already at the lower bound, I think that we would have expected the Bank to cut interest rates today. I can think of several reasons why the Bank would want to engineer a temporary depreciation in the CAD, and I can't think of a really good reason why it shouldn't.

Forex traders should take note: the Bank of Canada isn't bluffing.

Comments

[westslope]

I believe that net foreign investment (NFI) flows have a greater short-term influence over the currency values than changes in the current account. NFI appears to be positively correlated with commodity prices like oil and gold.

The recent increase in the Canadian dollar against the US dollar seems natural given the recent increases in many commodity prices, the exception being natural gas, and renewed confidence in global growth. When the flight-to-safety-capital starts to regain confidence and some ultimately leaves the US, those outflows should put additional downward pressure on the US dollar.

Somebody should tell the finance minister Flaherty to stop bragging about what great shape Canada finds herself in (relative to Iceland and the USA but he doesn't mention that of course).

Elsewhere, if investors fear that US inflation rates will jump much higher in the future, then they will continue to hedge against that perceived risk by buying stuff: gold, base metals and energy assets.

[Erin Weir]

I do not know if the Bank of Canada is bluffing, but it can and should intervene to moderate the exchange rate.

[westslope]

Canada has to decide whether it maintains to increase or decrease its reliance on the extraction and export of raw materials, and just how cyclical it wants its economy to be.

A more direct and expeditious way of taming the Canadian dollar rise would be to slow the pace of resource extraction (by extracting higher royalties, imposing higher environmental charges for water, etc.)and to sterilize capital inflows through sovereignty funds mandated to invest outside the country.

[westslope]

Coherently now...

Canada has to decide whether it wants to increase or decrease its reliance on the extraction and export of raw materials, and just how cyclical it wants its economy to be.

A more direct and expeditious way of taming the Canadian dollar rise would be to slow the pace of resource extraction (by extracting higher royalties, imposing higher environmental charges for water, etc.) and to sterilize capital inflows through sovereignty funds mandated to invest outside the country.