Patrick Grady
"Martin and Dodge Open a Can of Worms with Their Comments,"
Financial Post, Friday January 25, 2002, p.FP13

Finance Minister Paul Martin opened a cans of worms on Tuesday when he expressed the government's unhappiness with the weak Canadian dollar and said that it did not reflect the relatively strong position of the Canadian economy. This put Governor David Dodge of the Bank of Canada on the spot as he was scheduled to release the Bank's regular monetary policy update the next day.

While the policy update itself, which had to be prepared in advance, was silent on the question of the dollar, the Governor picked up on the Minister's comments. More specifically, he said "The signs of a pickup in economic activity in Canada are encouraging. But the recent movements of the Canada-U.S. exchange rate do not appear to have reflected these developments and this recent depreciation has not been helpful for the economy. Economic recovery in Canada does not hinge on the low levels of the Canadian dollar against the U.S. counterpart."

This runs counter to the conventional wisdom is that a lower dollar spurs exports and curtails imports thereby raising growth as long as it does not lead to domestic price increases. When pressed, the Governor replied that a low dollar was affecting business confidence negatively and thus not aiding a recovery.

Exchange markets have rallied since the double-barrelled comments from Canada's two senior economic policy managers. But will they hold. There could be renewed downward pressure on the Canadian dollar if market participants start to wonder if the Canadian government is worried about something that they don't know about.

The Street is abuzz with questions about exactly what the comments mean. Is the Bank of Canada now going to conduct monetary policy to support the dollar? And if so, how?

One possibility, which seems to find some support in the Minster and the Governor's comments, is that the market doesn't have a good understanding of the strong fundamentals of the Canadian economy. But this is hard to believe because there are hundreds of billions of dollars at stake and ignorance could be very costly. No, the big banks and other currency market participants have a big financial incentive to get all the information they can. It can't be that they don't know what's going on in Canada.

Another possibility is that the Bank is going to change the way it currently pursues monetary policy from an approach based on targeting inflation to something else. The inflation targeting approach, which has been in effect for a decade under three Governors, has been endorsed by Governor Dodge in numerous public statements. Since 1995, the target has been to keep the trend of inflation inside a target range of 1 to 3 per cent. The necessary corollary to this has been that the Canadian dollar has been allowed to float freely. As Governor Dodge said in a major speech last June in Edmonton, "there are only two options today in terms of explicit anchors for monetary policy: fixing the exchange rate or targeting inflation." This categorically denes the possibility of a monetary policy that tries to do both. There are obvious trade-offs involved.

What are the instruments at the Bank's disposal for supporting the dollar? There are basically two. The first is sales of foreign exchange reserves to purchase Canadian dollars on the open market. But even though Canada has $34 billion in foreign exchange reserves at its disposal, this is a relatively small sum in relation to the large daily volume of foreign exchange transactions. It would not be enough to stave off a decline for very long if the Canadian dollar were to come under serious downward pressure.

The second instrument is interest rate increases. Back in the summer of 1998 when the flight to the dollar triggered by the Russian bond default and the failure of the Long Term Capital Management pushed the Canadian dollar to its previous low of 63.11 cents, the Bank was only able to end the fall by dramatically raising interest rates a percentage point. Selling $4.5 billion in foreign exchange reserves did not do the trick. Interest hikes are the Bank's big guns to support the loonie.

The big question has to be: will the Bank be willing to raise interest rates to defend the Canadian dollar? Doing so hasn't been made any easier by the Bank's new policy of a fixed schedule for announcing changes in interest rates. To be effective in bolstering the dollar, interest rates need to be increased immediately when the dollar first comes under attack. Alternatively, not following any additional interest rate reductions such as might occur next week in the United States would support the dollar.

The fundamental question for monetary policy is what are the implications of possible interest-rate increases for inflation targeting. In December, the consumer price increase year-over-year was only 0.7 per cent and core inflation (as measured by the Bank excluding food, energy and indirect taxes) was only 1.6 per cent. According to the monetary update, the Bank expects inflation to stay this low in 2002. Thus any increases in interest rates will have to be made at a time when core inflation is likely to be in the bottom half of the Bank's 1 to 3 per cent target range. And with economic growth only expected by the Bank to average between 1and 2 per cent in the first half of this year, the interest rate increases would have to be made against the sombre backdrop of rising unemployment, which has already hit 8 per cent.

Last June in his speech in Edmonton, the Governor that "the real value of a floating currency lies in helping our economy to absorb some of the impacts of external shocks." As an example, he cited the value of a lower dollar in offsetting some of the impact of declines in commodity prices on the Canadian economy in 1997-98. He also cited its advantage in absorbing some of the pressures from large capital flows. This is probably the source of the recent downward pressure on the dollar as other major currencies such as the euro have also declined against the dollar. An obvious question is what if there are further reductions in commodity prices or capital outlows, will the Canadian dollar be allowed to drop further? Or will interest rates be increased?

The Questions raised by the sphinxlike comments of the Governor and the Minister of Finance need some answers. Are they proposing a fundamentally new approach to monetary policy or are they just trying to do a little innocent jawboning.