Why Higher Dollar Means Bank of Canada Can Keep Interest Rates Unchanged
The Canadian dollar is on a tear, and some think that a correction is due, but over the longterm the CDN dollar is strong given the nature of the economy. Bank of Canada Governor Mark Carney has noted the trend but also considers it some good news if the Bank of Canada is going to fulfill their pledge to keep interest rates the same for another quarter.
So why is it a good thing that the dollar is high if you’re going to plan to keep interest rates the same?
Simply put, in a global economy the laws of supply and demand hold true for foreign currency trades just anything else. So think about it for a moment: if the interest increase, that means that short term investments will adjust accordingly, and thus investment into Canadian financial instruments look better compared to other countries. As such, you’d find an increase in demand for the CDN currency thereby driving up the price.
If the Canadian dollar is around par with the American Greenback, then keeping the interest rate unchanged won’t cause a short term jump in demand for CDN $. If the bank were to increase interest rates then you’d certainly see a spike in appreciation for the CDN $ vs. the USD $. Canadians would be paying less for American dollars, our exports would be more expensive, but we’d be able to import more.
So as it stands the Bank of Canada doesn’t mind the higher dollar as it gives another strong reason why they can keep the interest rate unchanged for at least another quarter.
Today inflation data was released and it showed that inflation (a number that measures the overall change in a ‘basket’ of good) has increased beyond the 2% target of the Bank.
What does that mean and why does that increase inflation? To put simply (in theory), when prices increase that means you need MORE cash to buy the same thing. Thus you will demand (domestically and those abroad buying here) MORE cash. Increase in demand reduces supply of domestic currency and as such an appreciation occurs in the short term.
Now, that may be in the very short term, however, what happens if the price index goes up too much? 2% is the target for the Bank, since it’s above that means prices are increasing rapidly. The economy may be growing to fast essentially. Big purchases like houses may need a cool off. How would you do that? Simply increasing interest rates. But wouldn’t that appreciate the currency? Yes!
So now we have a conundrum. If the bank increases interest rates to slow down inflation and prevent the economy from growing bigger than can be sustained then the currency will appreciate. If they don’ move the currency stays the same, and then the economy grows at a faster rate (while keeping the export sector a bit happier).