Three reasons why the Bank of Canada is not trying to drive down the loonie

“The Bank of Canada’s most recent policy meeting this month revealed a growing dovish streak, raising questions about whether the bank is actively trying to drive down the loonie.”

Stephen Poloz

Reblogged from John Shmuel

It’s a policy approach that would make sense, considering the strength of the loonie has hurt Canadian exports in the past few years. The strategy of “talking down” a currency has been used to relatively successful effect in countries such as Australia and Norway.

But Charles St-Arnaud, Canada economist for investment bank Nomura, doubts the Bank of Canada is currently attempting something similar.

“While a weaker CAD would be welcomed by the Bank of Canada… we find that using the properties from the BoC’s projection model the size of the depreciation needed to compensate the loss in competitiveness and to bring back inflation to target would require a depreciation of CAD of between 25% and 30%,” he said. “A depreciation of the currency of this magnitude would be almost impossible to attain only through monetary policy and requires significantly lower commodity prices.”

Essentially, the loonie would need to become much weaker than it currently is for Canada to see any economic benefit. Driving it down by such a large margin would be extremely difficult and, even if it could be done, would create a whole host of other problems.

Mr. St-Arnaud points out others have argued the bank could create smaller benefits for the Canadian economy without going to such great lengths, but he counters those, too. Below, he lists three main arguments he’s heard for why the Bank of Canada is actively working to lower the loonie, and why he thinks they’re wrong.

1. Because he joined from EDC, Gov Poloz wants a weaker CAD: Interestingly, since Gov. Poloz took over the helm of the Bank of Canada, none of the policy decision communiqués have made reference to the currency and the reference to the strong Canadian has disappeared from Monetary Policy Reports. Furthermore, all is comment have pointed to the need for a flexible exchange rate that is determined by the market. Ultimately, we believe that the most important comments made by Governor Poloz since taking the helm of the BoC has been during his first public appearance when he said that ’the inflation target is sacrosanct’.

2. A strong CAD is the reason for the weakness in exports: Recent publications by the BoC suggests that the weakness in exports comes mainly from ongoing competitiveness challenges over the past decade that have been exacerbated by the appreciation of CAD over the period. While it is tempting to conclude that a weaker currency would solve the problem, the BoC also showed that the appreciation was driven by fundamentals and CAD is currently around fairvalue and, hence, hard to reverse. Moreover, while a weaker CAD would push exports higher, simulations from the BoC’s projection model suggests the magnitude of the FX move needed to push growth significantly above potential and close the output gap more rapidly is also big.

3. A weaker CAD would help bring inflation to target: Recent Bank of Canada research papers have shown that the pass-through from a weaker exchange rate to inflation has diminished over the past few decades. Moreover, simulation from the BoC projection model suggest that the impact of a CAD depreciation on inflation is also weak and would require a large depreciation to bring back inflation to target.

Read Original Article

Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s