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

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If battling decades-high inflation wasn’t difficult enough, the Bank of Canada now faces the added burden of a struggling bank, which has slumped in recent weeks.

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The Canadian dollar fell to a two-year low below 73 US cents in late September. Although it has breached the 73-cent mark in recent days, the drop from the 77-cent range it was trading in early last month may add to the country’s inflation woes by importing, especially those from the United States. , Canada’s largest, most expensive trading partner.

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

Tal added that given the unusual dynamics of the current recession, the central bank “may have to keep interest rates higher for longer than perceived” in the face of these additional inflationary pressures.

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

Tal does not expect these factors to translate into a higher inflation reading in the next data print, as commodity prices are working in the opposite direction and have already brought inflation below eight percent. However, he said he believes the lagging wolf will affect how quickly the Bank of Canada can return inflation to its two per cent target.

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Bank of Canada Governor Tiff Macklem acknowledged that the wolf is proving problematic, telling an audience in Halifax on Oct. 6 that the weaker exchange rate is offsetting at least some of the disinflationary effects of prices lower raw material costs and smoother supply chains.

“We cannot count on easing pressure on global prices to reduce inflation in Canada,” Macklem said in prepared remarks posted on the central bank’s website. “At the very least, the improvement in global factors will take time to filter through to Canadian inflation. And the recent depreciation of the Canadian dollar against the strength of the US dollar will offset some of this global improvement by making goods and vacations from the US are more expensive for Canadians.”

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

When oil topped US$100 this year, the wolf did not fly in tandem, barely glancing at the US80 cent level. Macklem pointed to the lack of significant investment in oil projects dampening demand for Canadian dollars as one of the reasons this connection went unmoored.

The inflationary impact of the loonie is making life difficult for the Bank of Canada

Benjamin Tal, Deputy Chief Economist at CIBC Capital Markets

Now, with oil falling and brutal policy from the US Federal Reserve leading many to predict that US interest rates will eventually rise more than Canada’s, the mild is falling, putting more pressure on policy of interest rate here.

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Canada is not alone in its foreign exchange struggles. The Fed’s hawkishness has sent the greenback soaring against currencies around the world. The Canadian dollar has actually performed better against the greenback than the G7 currencies, but Canada’s reliance on the US as a trading partner increases the impact on our economy.

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

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

“It could be six to 12 months before the currency’s effects show up, if at all,” Schamotta said.

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

That’s because there are some factors at play that could reduce the economy’s sensitivity to exchange rates. On the one hand, the cost burden on supply chains is heavily dependent 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 making it more difficult for companies to raise prices, are working together to reduce sensitivity to exchange rates.

Schamotta said exchange rate-driven inflationary pressures are usually short-lived and central banks would avoid overreacting.

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“Although academics have been trying to identify one for decades, no one has ever identified a fundamental type of equilibrium shift that the central bank can target,” Schamotta said. “The best policymakers can do is adjust interest rates to reflect the fundamentals of domestic supply and demand and let the currency act as a balancing mechanism.”

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

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A lower loonie is expected to stick with Canadians for a while longer. Bank of Montreal senior economist Sal Guatieri said in an Oct. 5 note that it will likely depreciate further this year, driven by interest rate differentials between Canada and the United States.

Tal shared that sentiment, noting that an unbalanced market will keep the loonie lower for longer.

“We don’t see the Canadian dollar improving until late 2023, when interest rates stop rising and the market basically comes to some sort of balance, and as safe-haven flows to the U.S. it will be reversed,” Tal said. “But in the meantime, we’re going to have a situation where the Canadian dollar will remain under pressure.”

• Email: shughes@postmedia.com | Twitter: Steph Hughes95