Canada’s currency was on a roll. On January 18, Bloomberg News observed the loonie’s 3% gain in 2017 represented the best start to a year since Canada adopted a floating exchange rate in 1970. And then the Bank of Canada came along.
Hours after Bloomberg published its story, the central bank completed its latest round of policy deliberations. The Governing Council left the benchmark interest rate unchanged at its ultra-low setting of 0.5%, but policy makers were less than enthusiastic about the Canada’s prospects. In the policy statement, the Bank of Canada noted that, “in contrast to the United States, Canada’s economy continues to operate with material excess capacity,” and that, “the Canadian dollar has strengthened along with the US dollar against other currencies, exacerbating ongoing competitiveness challenges and muting the outlook for exports.”
The central bank also released its latest quarterly report on the economy, which says, “export growth will be limited by the recent appreciation of the Canadian dollar, alongside that of the U.S. dollar, vis-à-vis most other currencies.” And Governor Stephen Poloz and Senior Deputy Governor Carolyn Wilkins held a press conference to discuss the new outlook. In his opening statement, Poloz said Canada’s dollar has “held its own” against its U.S. counterpart, while rising in value against “most other currencies.” That means “Canada will lose competitiveness in the U.S. market compared with exporters from other countries,” Poloz said. Later, in a response to a question on why the Canadian dollar remains buoyant despite so many negatives, the governor said Canadian asset prices tend to track what’s happening in the U.S. because, historically, when the American economy grows, the Canadian economy grows with it. “We want to make sure that we all understand that Canada has quite a bit of excess capacity, room to grow, for some time yet before reaching that stage,” Poloz said. “And so that correlation shouldn’t be as high as it has been.”
Got the message? The Bank of Canada met the loonie’s attempt to take flight with some of its freest commentary ever on a subject that policy makers typically try to avoid. The only equivalents I can think of came in 2002, when former governor David Dodge described the dollar’s plunge below 63 U.S. cents as “unhelpful,” and in 2009, when former governor Mark Carney became uncomfortable with the dollar’s post-crisis appreciation. “Markets should take seriously our determination to set policy to achieve the inflation target,” Carney said. “Markets sometimes lose their focus. We don’t lose our focus.”
Canada’s dollar dropped two cents over the two days that followed the Bank of Canada’s latest commentary. Will this please Poloz? Probably, although he never would admit it in public. The exchange rate is a sensitive subject. In September, 2014, Poloz devoted an entire speech to it in Drummondville, Quebec. He had been leading the central bank for a little more than a year and he had been unable to shake the perception that he favoured a low-dollar policy. “I think he’ll pay more attention to the exchange rate,” David Laidler, an economics professor at the University of Western Ontario, Poloz’s alma mater, told me in May 2013 after it was announced that Poloz would replace Carney. “The next time the exchange rate goes to $1.05 (U.S.), you might find some more direct statements about that than you have seen under previous regimes.”
Poloz insisted in Drummondville that he had no such bias. There is a maxim in monetary policy that you can have only one target—and the Bank of Canada’s target is inflation. By way of example, he shared with his audience what the central bank would have had to have done to prevent the Canadian currency from climbing to par with the U.S. dollar in early 2008. The value of the Canadian dollar is linked to the price of oil, and oil had surged to about $100 per barrel. To counteract those forces, the Bank of Canada could have cut interest rates, opening up a gap between the cost of money in Canada and the United States, making U.S. assets relatively more attractive to fixed-income investors. The Canadian dollar’s value touched 85 U.S. cents in 2005. To have kept it there, the central bank would have had to have dropped its benchmark interest rate to almost zero from 4%, Poloz said. The combination of higher oil prices and ultra-low borrowing costs would have caused the economy to overheat, driving annual inflation to 4%, well outside the central bank’s comfort zone of 1% to 3%. Companies that were being hurt by a strong currency would instead get whacked by higher input costs. That’s why central bankers say they can achieve only one target. And that’s why Poloz dislikes the suggestion that he is trying to manage the value of the currency. “Trying to control the loonie is off the table, as far as we are concerned at the Bank of Canada,” Poloz said in Drummondville. “A floating loon is a thing of beauty, and so is a floating loonie, at least from this economist’s perspective.”
So what was Poloz doing on January 18, if not trying to control the loonie? The Bank of Canada clearly saw the dollar’s strength as a headwind. It even appears to think that Canada’s currency is overvalued, if not against the U.S. dollar, then certainly against currencies such as the Mexican peso.
Except the central bank didn’t quite say any of that. We are forced to read between the lines and divine meaning from various clues. Why so much mystery? Blame the men and women hedging your currency risk. Donald Trump notwithstanding, policy makers are extremely sensitive about becoming the source of instability in financial markets. Economists and traders are smart people, but they still will put more stock in an inadvertent comment by an official than they will in their own analysis of the economic outlook. If Poloz or Wilkins had actually said they thought the Canadian dollar was too strong, they would have become the story in currency markets. Rather than figuring it out for themselves, traders would start to rely on commentary from officials. “The bank can’t do its job well unless the market does its job well,” Poloz said in Drummondville. Ambiguity allows flexibility, and it also forces market participants to do what they do best: set prices. Those prices help the central bank decide where it should set interest rates.
Poloz’s Drummondville speech is informative in other ways. He sketched a hypothetical situation that two years later has become his reality. “We can imagine a scenario where the U.S. economy was picking up speed and our economy was lagging,” Poloz said. “In such a situation, U.S. interest rates might rise at a time when maintaining our inflation target would require that Canadian interest rates remain unchanged. If we were trying to hold the exchange rate unchanged instead of targeting inflation, we would probably need to match U.S. interest rate increases in lockstep; but doing so would risk pushing our inflation rate back below our target. Again, attempting to control the exchange rate would mean giving up our independent monetary policy.”
But reality hasn’t quite played out as Poloz imagined. The divergence in policy between the U.S. Federal Reserve and the Bank of Canada is happening: the Fed likely will raise interest rates at least a few times in 2017, while the Canadian central bank likely will do nothing at all. Yet the value of the currency remains unchanged, which has become a barrier to the central bank conjuring the growth it needs to hit its inflation target.
“Markets are not perfect,” Poloz said in Drummondville. And now we know that when Poloz sees market imperfections, he won’t be shy about offering traders some other things to consider when deciding where to place their money. Guidance if necessary, but not necessarily guidance.