Monetary conditions in Canada are still quite restrictive, which means the Bank of Canada needn’t mimic further hikes by the Fed. Read more.
Some depreciations aren’t a problem. Suppose the Canadian dollar falls relative to the U.S. dollar because demand falls for Canadian goods. If that happens, foreigners require fewer Canadian dollars and our dollar depreciates — just as it would appreciate if the demand for Canadian goods rose. In such cases, the exchange rate acts as a shock absorber: a depreciation makes Canadian goods cheaper, causing a rebound in foreign demand. An appreciation does the opposite.
But suppose the Canadian dollar falls relative to the U.S. dollar because investor preferences change — as, for example, when nervousness causes a flight to the U.S. dollar. That kind of depreciation will make Canadian exports cheaper for foreign buyers and imports more expensive for Canadians. That increases inflation here at home, and, as a result the bank may need to respond with tighter monetary policy.
In our view, even if the recent decline in the Canada-U.S. exchange rate is mainly due to global rebalancing toward the U.S. dollar — the so-called “safe haven effect” — and bumps inflation up a little, monetary conditions in Canada are still quite restrictive, which means the bank needn’t mimic further hikes by the Fed.
Real policy interest rates — calculated by subtracting inflation from nominal rates — are rising in Canada, and at a faster pace than in the U.S. And they’re whatThe bank is targeting 4.5 per cent, while the range the Fed is aiming for is 4.5 to 4.75 per cent. But inflation is lower in Canada and is falling faster. Headline inflation in January was 6.4 per cent in the U.S., compared to 5.9 per cent in Canada. Real rates are still negative in both countries but less negative here.
Our other main reason for believing the bank should not follow the Fed in lock step is that the Canadian economy is showing more signs of weakness than the American. Real growth in Canada was stagnant in the fourth quarter, compared to an annualized growth rate of 2.7 per cent in the U.S. In part, this reflects the fact that the bank began tightening before the Fed did. As the bank notes, this tightening has already reigned in the growth of spending.
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