Canadian dollar making Bank of Canada’s fight against inflation harder

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If battling decades-high inflation wasn’t hard enough, the Bank of Canada is now facing the added burden posed by a struggling loonie, which has plunged in recent weeks.

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The Canadian dollar fell to a two-year low below 73 U.S. cents at the end of September. Though it has clawed its way back above the 73-cent mark in recent days, the drop from the 77-cent range in which it was trading earlier last month may add to the country’s inflation woes by making imports — especially those from the United States, Canada’s biggest trading partner — more expensive.

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“I think it’s already happening that the inflationary impact of the loonie is complicating the Bank of Canada’s life,” said Benjamin Tal, deputy chief economist of CIBC Capital Markets.

Tal added that given the unusual dynamics of the current downturn, the central bank “might need to keep interest rates higher for longer than perceived” in the face of such additional inflationary pressures.

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In a normal economic downturn, rising interest rates would slow down the consumer. However, Tal noted the recent slowdown has been unique in that the labour market has remained robust — supporting wage growth for lower income brackets — while substantial savings amassed during the pandemic are giving the consumer the purchasing power to continue spending in the face of rising prices.

Tal doesn’t expect these factors to translate to a higher inflation reading in the next data print since cooling commodities prices are working in the opposite direction and have already brought inflation below the eight per cent mark. However, he said he believes the lagging loonie will impact the speed at which the Bank of Canada can bring inflation back down to its two per cent target.

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Bank of Canada governor Tiff Macklem acknowledged the loonie is proving troublesome, telling an audience in Halifax, on Oct. 6 that the weaker exchange rate is offsetting at least some of the disinflationary effects of lower commodity prices and smoother supply chains.

“We can’t count on easing pressure on global prices to lower inflation in Canada,” Macklem said in prepared remarks published on the central bank’s website. “At a minimum, improving global factors will take time to filter through to Canadian inflation. And the recent depreciation of the Canadian dollar in the face of U.S.-dollar strength will offset some of this global improvement by making U.S. goods and vacations more expensive for Canadians.”

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Normally, the Canadian dollar would have risen with commodity prices, as it tends to track the price of oil. But that didn’t happen this summer. In July, Macklem said that because the country wasn’t seeing commodity-linked appreciation in the loonie that it expected, the central bank would have to do more of the heavy lifting through interest rates.

When oil ran above US$100 this year, the loonie did not take flight in tandem, barely glancing at the 80-U.S.-cents level. Macklem pointed to the lack of major investment in oil projects having dampened the demand for Canadian dollars as one of the reasons this connection became unmoored.

The inflationary impact of the loonie is complicating the Bank of Canada’s life

Benjamin Tal, deputy chief economist, CIBC Capital Markets

Now, with oil falling and hawkish U.S. Federal Reserve policy leading many to predict U.S. rates will ultimately rise higher than those in Canada, the loonie is actually falling, putting more pressure on interest rate policy here.

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Canada is not alone in its currency struggles. The Fed’s hawkishness has sent the greenback surging against currencies around the world. The Canadian dollar has actually performed better against the greenback than its counterpart G7 currencies, but Canada’s dependence on the U.S. as a trade partner magnifies the impact on our economy.

The extent of currency impacts has been the subject of some debate.

In recent decades, a 10 per cent drop in the Canadian dollar has translated into a short-lived half per cent upward shock in the annualized headline inflation reading, according to Karl Schamotta, chief market strategist at Cambridge Global Payments.

“It can take six to 12 months before currency effects show up, if they arrive at all,” Schamotta said.

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But Schamotta added that these impacts are small and might surprise observers.

That’s because some factors are at play that could blunt the economy’s sensitivity to exchange rates. For one, the cost burden in supply chains leans heavily on domestic services (such as marketing and logistics), which are typically less sensitive to exchange rate changes.

We don’t see the Canadian dollar improving until later in 2023

Benjamin Tal

Falling commodity prices, dollar hedges already in place by importers and the nature of exchange rate depreciation — which is typically associated with falling aggregate demand that makes it harder for companies to raise prices — are all working in tandem to lower sensitivity to exchange rates.

Schamotta said exchange rate-driven inflation pressures are typically short-lived and that central banks would avoid a knee-jerk overreaction.

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“Although academics have tried to pinpoint one for decades, no one has ever identified a fundamental equilibrium exchange rate that the central bank can target,” Schamotta said. “The best policymakers can do is adjust interest rates to reflect domestic supply and demand fundamentals, and let the currency act as an equilibrating mechanism.”

Unless there is clear evidence of significant loonie-driven inflation, Schamotta said the Bank of Canada is unlikely to adjust policy settings or to try to talk up the currency markets.

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A lower loonie is expected to stay with Canadians for a while longer. Bank of Montreal senior economist Sal Guatieri said in an Oct. 5 note that the loonie will likely depreciate further this year, driven by the Canada-U.S. interest rate spreads moving against it.

Tal shared this sentiment, noting an imbalanced market will keep the loonie lower for longer.

“We don’t see the Canadian dollar improving until later in 2023 when interest rates stop rising and the market basically gets into some sort of equilibrium, and to the extent that the safe haven flow to the U.S. will be reversed,” Tal said. “But in between, we will have a situation in which the Canadian dollar will remain under pressure.”

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