The Bank of Canada says a stronger loonie has re-emerged as a risk to its outlook for inflation, warning that the currency’s recent rise could weaken the competitiveness of the country’s goods and services. The Canadian dollar has shot up to its highest level since early 2018, chiefly because of weakness in its U.S. counterpart, the Bank of Canada said in a monetary policy report released on January 20.

A stronger dollar was also explicitly included on the monetary policy report’s list of risks to the Bank of Canada’s inflation outlook for the first time since July 2011, when oil prices were almost double what they are today and the loonie was trading at around US$1. Bank of Canada Governor Tiff Macklem said that a Canadian dollar that is increasing in value because of made-in-Canada reasons “tends to act mostly as a shock absorber,” such as a higher price of oil that is matched by a more valuable loonie.

“On the other hand, what we’re seeing now is most of the appreciation in the Canadian dollar is coming because of a broad-based depreciation of the U.S. dollar,” Macklem told reporters during a press conference. “That’s not a made-in-Canada development. So, the exchange rate is becoming a factor in its own right in our projection.”

Macklem’s comments followed the Bank of Canada’s decision to leave its key interest rate unchanged at 0.25%. The loonie rose from about 78.7 cents US pre-decision to more than 79 cents US shortly after.

In making its announcement, the central bank said the world is still rife with uncertainty, and that the economic outlook continues to hinge on the coronavirus pandemic and vaccine rollouts. A stronger dollar could throw another wrench into that economic outlook.

“Appreciation of the Canadian dollar creates direct downward pressure on inflation by lowering the prices of imports,” the monetary policy report said. “Further appreciation of the Canadian dollar could slow output growth by reducing the competitiveness of Canadian exports and import-competing production. Slower output growth would also imply more disinflationary pressures.”

Inflation is key to the Bank of Canada’s monetary policy decisions, namely the setting of its key interest rate. The bank’s target for inflation is a 2% year-over-year increase in the consumer price index (CPI), which measures the change in cost of a basket of products.

The Bank of Canada said on January 20 that CPI inflation has climbed to the “low end” of its 1% – 3% target range in recent months and that it is forecast to temporarily reach around 2% in the first half of 2020. Inflation is “expected to return sustainably” to 2% in 2023, the bank said.

The Bank of Canada’s latest projection is based on an exchange rate of 78 cents US, the prevailing rate at the time of the projection, a two-cent increase over October’s forecast. Moreover, the bank said the Canadian economy shrunk by 5.5% in pandemic-stricken 2020, although it predicted a 4% rebound in 2021.

“We think there’s a disconnect between the Canadian dollar and economic fundamentals,” said Darcy Briggs, a Calgary-based portfolio manager at Franklin Templeton Canada. “It will have an impact on the economy if it continues to strengthen.”

Briggs said Canada’s currency is being pushed higher by a “reflation trade,” or a bet that the global economy is in the early stages of a recovery from one of the most epic collapses in history. The outlook has emboldened currency traders to take on more risk, prompting them to sell U.S. dollars and use the proceeds to place bets on other currencies, including the loonie. “It’s tightening financial conditions,” Briggs said of the stronger exchange rate, offsetting some of the stimulus provided by lower interest rates.

The Bank of Canada also said that it would continue its bond-buying quantitative easing program as is for now, purchasing at least $4 billion a week in debt, although that could be adjusted as the economy improves. “Vaccines are riding to the rescue of the Bank of Canada’s economic outlook,” wrote Avery Shenfeld, chief economist of CIBC Capital Markets, in a note to clients. “But with the pandemic still raging for now, the Canadian dollar perhaps looking a bit too strong and inflation too low for its liking, the Bank of Canada underscored that it will be very patient in deciding when to take its foot off the gas.”

Source: Financial Post