Bank of Canada kept their target overnight rate at 0.5% this week. Judging by the forex market reactions, this came as a surprise to some. We have looked at the uncertain behavior of Poloz as governor in the past and now we are seeing the consequences. When he surprised the market with a rate drop earlier this year he changed the way people thought about the BoC. Our central bank was always very clear about its intentions and so the rate announcement days were always more of a formality to announce what everyone knew was coming. Now, because of this surprise it is going to take years for people to once again trust or think they understand what the BoC is doing.
On the BoC website they list four major responsibilities:
- Monetary policy: The Bank influences the supply of money circulating in the economy, using its monetary policy framework to keep inflation low and stable.
- Financial system: The Bank promotes safe, sound and efficient financial systems, within Canada and internationally, and conducts transactions in financial markets in support of these objectives.
- Currency: The Bank designs, issues and distributes Canada’s bank notes.
- Funds Management: The Bank is the “fiscal agent” for the Government of Canada, managing its public debt programs and foreign exchange reserves.
For years this meant that any actions they took regarding interest rates were almost purely to control inflation. They had many public statements that the Canadian dollar was free to float and that they would not participate in currency manipulation.
Now we are in a new situation. The reasons for lowering interest rates do not appear to be quite as clear. Poloz spoke many times about taking out “insurance” against a slow economy and that lower interest rates were required to combat low oil prices. These are not direct inflation issues. Is there an argument to be made that inflation would become a problem as a result of these situations if nothing had been done?
The drop in oil prices was caused not only by a high and regular supply but also by a massive drop in demand. With less people wanting to buy the oil we produce, there is less demand for Canadian dollars to buy that oil. This devalues our currency. This is why when oil prices drop drivers in Canada do not see large drops in prices at the pump; barrels of crude are priced in US dollars. Lowering the target overnight interest rate also devalues our currency. So we get two forces acting to push our dollar down.
We have seen over the last year that our dollar lost about 30% of its values versus the USD. This would mean that any goods that we import become more expensive while anything we export becomes cheaper for outsiders to buy. Have you noticed that most of the things you buy online are not that great a deal anymore? That is our weak dollar at work. However, these increased prices for online goods are likely not included in the basket of goods that are used to calculate inflation. Any imported food however would be more expensive and would be included in CPI, although not core, inflation. So perhaps that was the plan. Increase the prices of consumer goods through currency devaluation to push inflation a bit higher since it was slightly below target.
More likely, the rate cuts were targeted at companies that make most of their income in USD or foreign currency. Any company that makes money internationally but has Canadian employees got a 30% discount on their labour costs this year. (Did you feel that pay cut? They were pretty quiet about it.) This is good for the economy as it keeps people employed.
It is safe to say that the actions of the BoC fall more in line with the original Bank of Canada act who’s preamble reads:
WHEREAS it is desirable to establish a central bank in Canada to regulate credit and currency in the best interests of the economic life of the nation, to control and protect the external value of the national monetary unit and to mitigate by its influence fluctuations in the general level of production, trade, prices and employment, so far as may be possible within the scope of monetary action, and generally to promote the economic and financial welfare of Canada;
Using the BoC powers to promote the economic and financial welfare of Canada is fine but until Poloz and the rest of the board start making their intentions clear we will continue to see uncertainty on the exchange markets. This is good for forex traders but should be rather embarrassing for a central bank.