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Debate rages over impact of soaring Canadian dollar

Section: Daily Dispatches

By Louise Egan
via Yahoo News
Wednesday, September 19, 2007

OTTAWA, Canada -- The Canadian dollar's flight toward parity with the U.S. dollar has reignited debate over the impact of the strong currency on inflation and on Bank of Canada interest rates.

One leading bank, Toronto-Dominion Bank, issued a report on Wednesday disputing the widespread view that a soaring Canadian dollar inevitably dampens consumer inflation. The Bank of Canada, it argues, is therefore still very much in the hot seat in the fight against inflation and may need to hike rates further.

"The Bank of Canada should expect to receive little help from the stronger Canadian dollar in its effort to remove the existing inflationary pressures in the Canadian economy," wrote Millan Mulraine, economics strategist, in the TD report.

Others see evidence that the currency's appreciation has softened prices, at least imported consumer goods. That has allowed the central bank to leave its overnight lending target on hold in an environment that would otherwise warrant a tightening of monetary policy.

"I think there is evidence that a strong Canadian dollar has not only impacted inflation but has also altered the course for the Bank of Canada," said Warren Lovely, senior economist at CIBC World Markets.

"The Bank of Canada was able to stop raising rates before the Fed and at a lower level largely because of the Canadian dollar appreciation."

Canada's dollar has extended 30-year highs over the past few days and most economists now expect it to push past parity with the U.S. dollar by year-end. Up 15 percent so far this year, the currency last had the same value as the greenback in November 1976.

After raising interest rates in July, Bank of Canada Governor David Dodge said the stronger Canadian dollar meant lower import prices and less pressure on inflation.

The bank kept its benchmark rate unchanged at 4.50 percent early this month as global credit market turmoil overshadowed inflation fears.

Inflation eased in August to 1.7 percent and core inflation, watched by the central bank, also fell to 2.2 percent.

TD's Mulraine noted a "perplexing" stickiness of consumer prices, based on an analysis of data from 1998 to 2007 that showed no significant evidence of pass-through of currency movements to the things that most people buy. The same trend has been noted across Group of Seven nations, he said.

However, import prices have dropped meaningfully because of the appreciation, he said. Producer prices have also fallen but to a lesser extent, but the savings have not been handed down to consumers.

Proof of this is that Canadians still flock to U.S. shopping malls to enjoy the discounts, says Stewart Hall, market strategist at HSBC Canada. "Anecdotal evidence suggests that you are paid to go the distance and cross the border, which perhaps speaks to a pricing dislocation," he said.

But Canadian buyers are feeling the savings when they buy imported consumer goods, argues Lovely at CIBC, though the impact could take up to two years to be felt.

Prices of services, particularly in the fiery housing sector, are not influenced as much by currency swings so the Bank of Canada may still have to tackle those pressures through a rate hike.

"We're still seeing the impact of that currency appreciation on core inflation. There will continue to be a natural, inherent lag in that process that means it'll continue to play out for some time yet," he said.

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