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Bank of Canada Cuts Rate, ‘Loonie’ Suffers Unflattering Rout

0 721 Economic

by Alex Carrick

Some key portions of Canada’s economy – the energy sector and government royalties, to name two examples − are being damaged by the sharp drop in the world price of oil.
2015 01 26 Bank of Canada Rate Graphic

The Bank of Canada’s response has been to cut its key policy-setting interest rate by 25 basis points, where 100 basis points equals 1.00%. The ‘overnight rate’ now stands at 0.75%, down from the 1.00% level that was previously in place for four-and-a-half years.

Many in the media quickly concluded this was an effort to support the nation’s housing market.

I don’t buy it. Pretty much everybody, by which I mean the economic and financial community at home and abroad, has concluded Canada’s housing market is overheated. Nor has there been any indication of the widely-anticipated soft landing. New home starts for all of 2014, at 188,900 units, were almost exactly the same as in 2013, 187,700 units. The change was a flat +0.7%.

It’s true that Toronto cooled last year, but extra heat from Calgary stoked the national fire.

Calgary’s time at a boil will end as energy sector firms trim investment spending and payrolls.

But a major problem remains. For years, Canadians have been lectured on the irresponsible manner in which they have allowed their household debt (of which mortgage obligation is the largest portion) to disposable income ratio to careen out of control. It’s approaching 170%, an all-time high, and considerably out of line with what is prevalent in most other countries.

The BOC rate cut, which encourages further borrowing, will only make this situation worse.

So no, I don’t believe the one-quarter percentage-point drop in the overnight rate was primarily designed to help Canada’s housing market. That’s peripheral to the main matter.

Rather, it was meant to influence the exchange rate.

In the past, the Bank of Canada has always maintained that the one and only purpose of its monetary policy has been to manage the Consumer Price Index (CPI); specifically to keep year-over-year ‘core’ inflation within a range of +1.0% to +3.0%.

Currently, lower oil prices do threaten to send inflation into a tailspin. The price of gasoline in December 2014 was -16.6% compared with December 2013. (In the U.S., it was -21.0%.)

But it’s hardly credible that the Governor of the BOC orchestrates an interest rate change, then says to himself, “Say, that will probably have an impact on the exchange rate too.”

All protestations to the contrary, there has been an accumulation of evidence that the BOC is targeting not only inflation, but also the exchange rate. This has been especially true under the leadership of the BOC’s latest Governor, Stephen Poloz. As former head of the Export Development Corporation, he has a workplace background in the foreign trade sector. He knows the ‘worth’ of a diminished ‘loonie’ (Canada’s currency) for certain segments of the economy.

Let’s summarize. The dramatic plunge in the world price of oil has been followed in Canada by a relatively minor, but mostly unexpected, cut in the BOC’s official interest rate. The double whammy has sliced the value of the Canadian dollar from higher than parity with the U.S. dollar to approximately 80 cents at present.

A decline in excess of 20% isn’t just an adjustment; it’s a rout.

Who benefits from an 80-cent loonie?

Any domestic firm that sells a product designated in U.S. dollars. That includes oil and gas companies.

Any domestic firm currently selling or hoping to sell goods and/or services into the U.S. marketplace. The currency conversion calculation provides a price cut in U.S. dollars, while not actually altering the Canadian price.

Retail firms. Fewer Canadians will see any advantage in going across the border to shop, or in going online to purchase goods from U.S.-based Internet firms. At the same time, import competition from U.S. shopkeepers will be hampered by a price hike. (And let’s not forget that Canadian consumers will be revved up on account of savings at the gas pump and cheaper borrowing costs.)

Who loses from an 80 cent loonie?

Some of the answers to that question require explanation. They can sound esoteric and of concern only to worry-wart economist ‘wonks’. First, though, there are some obvious drawbacks.

Anybody who wants to travel to the U.S. will find the experience to be more financially challenging. (There’s extra incentive for Americans to travel to Canada, but so far they’ve preferred to stay in their own back yard.)

Daily news reports keep stressing how positive an 80-cent loonie is for Canada’s manufacturing sector; and that there are already indications of a pick-up in investment north of the border.

But firms located in Canada that want to buy American equipment or machinery will have to pay a higher price. Some key purchases will be postponed or set aside. Canadian companies have often been accused of failing to adequately invest in the productivity-enhancing means to stay competitive in today’s global mainstream. An 80-cent loonie will exacerbate that problem.

There’s an effect that’s even more dangerous. A falling currency dulls what is supposed to be razor-sharp corporate decision-making. The burden for strategy ‘to stay in the game’ is shifted to an exchange rate adjustment.

There can also be simmering speculation about a further devaluation. Who thinks the Canadian dollar’s slide will stop at 80 cents? Long-term, nobody wants to put money into a country where the value of its currency may continue to slip.

Finally, and perhaps most important of all, once a foreign investor has been handed a reason to abandon Canada, it may take a prodigious effort and fortuitous circumstances (e.g., luck) to entice them back

The 80-cent Canadian dollar can easily be interpreted as one more sign that Canada’s economy is falling short of what it should be.

Let’s hope the ‘planned’ drop in the value of the loonie proves to be a brilliant move that forestalls an investment exodus. And that it’s not, instead, a panic response by a central bank that sees the country over which it has monetary oversight descending into an economic pickle.

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