The Canadian dollar has dipped against the US dollar following the Bank of Canada's decision to hold its key interest rate at five per cent.Paul Chiasson/The Canadian Press
Kevin Yin is a contributing columnist for The Globe and Mail and an economics doctoral student at the University of California, Berkeley.
On June 5, Canada became the first G7 nation to lower interest rates, with more cuts looming on the horizon. Detractors have sounded the alarm on deviating too much from the U.S. Federal Reserve – which has not yet moved to trim rates – citing the danger of a collapsing Canadian dollar. But there is much less risk than people think, both in terms of how much the loonie’s value will fall and how that fall would affect the wider economy.
Interest-rate differences influence currency exchange rates because they represent the difference in returns on holding Canadian-dollar assets versus U.S.-dollar ones. Since inflation remains persistent in the United States, the Federal Reserve is expected to continue holding rates high for the near future.
Thus, when the Bank of Canada lowers its rates and the U.S. doesn’t, investors move their money away from Canadian bonds and toward U.S. Treasuries, selling Canadian dollars for U.S. ones. This sell-off is what the monetary policy hawks in Canada are worried about.
This mechanism is real, but the magnitude is overstated. Bank of Canada Governor Tiff Macklem said recently the central bank was “certainly not close” to the limit of how much it can diverge from U.S. or global rates. Historical evidence suggests the Bank of Canada can deviate up to 100 basis points (one full percentage point) away from the Federal Reserve rate without much impact on the exchange rate.
The last time we lowered rates significantly more than the Americans – in that case, by more than 200 basis points – the loonie fell about 10 per cent. This was after the Mexican peso crisis, which began at the end of 1994 after the country began posting large budget deficits. In the following years, the crisis spilled over heavily into Canada because it, too, was running deficits, and investors were wary of lending to highly indebted nations.
As a result we cut rates much more rapidly than the less-affected U.S. The spread between our interest rates reached a peak of 250 basis points, far more than we would expect under today’s circumstances. Yet even then, the loonie only fell to a low of 63 US cents from 71 US cents before the crisis. That’s a much higher minimum than the 50-cent low predicted by one pessimistic portfolio manager for our current situation. In other words, it takes a gargantuan spread to get a significant level of depreciation.
We also need to consider the extent to which a depreciating currency is even an issue. In our case, it isn’t. Contrary to popular belief, the strength of a country’s currency isn’t some measure of the health of its economy at large. While it does tell us something about the macroeconomy, there is no “right” value for the loonie that is necessarily better or worse for us. The number merely reflects supply and demand forces determined in large part by interest-rate spreads and capital outflow risk.
Thus any concerns about the Canadian dollar’s falling value should be about how it affects other aspects of the economy, particularly prices and output. But a slightly weaker loonie should not have much impact on inflation, nor harm the broader macroeconomy.
When it comes to inflation, Canadians are primarily worried about how a depreciated dollar will raise import costs, and thus consumer prices. But inflation has not responded much to significant changes in the Canadian-U.S. exchange rate over the past 25 years. The National Bank of Canada estimates that even a 10-per-cent depreciation in the loonie would only add a maximum of 35 basis points to core inflation.
With more than 80 per cent of our consumption produced domestically and half of these expenses on untradable services, import prices only affect a small portion of our consumption. Moreover, even on goods that are imported, much of the final price depends on domestic services that transport and sell the products. Thus the pass-through on to consumer prices is small.
In terms of broader economic risks, there really aren’t any for the levels of depreciation we would be looking at. By making our exports cheaper for U.S. buyers and raising demand for domestically produced goods instead of foreign ones, a devalued loonie tends to expand the economy, not shrink it.
It takes a rapid sell-off of currency and subsequent bank failures to hurt output. But for that to happen, we would first observe enormous current account deficits, which measure our dependence on foreign funds. These deficits would need to on the order of 7 per cent to 8 per cent of GDP, as was the case for Thailand in 1997 and Mexico in 1994. Canada’s deficit is hovering around 0.3 per cent.
Caution in policy is helpful and there are legitimate concerns to be raised about additional rate cuts. But these have little to do with the Canadian dollar’s value or tying ourselves to Federal Reserve policy. With the Canadian economy in dire straits, let’s not overstate the barriers to providing relief