Exchange rate could be recovery headwind
Central bank signals economic outlook is materially affected, Kevin Carmichael says.
The Bank of Canada has identified a new headwind that could offset some of the good news related to the earlier-than-expected arrival of COVID-19 vaccines.
Governor Tiff Macklem and his deputies on the Governing Council made explicit mention of the exchange rate for the second consecutive time while updating their interest-rate stance, a signal that the dollar's recent strength could reduce what Canada might otherwise expect to earn from exports.
“News on the development of effective vaccines is providing reassurance that the pandemic will end and more normal activities will resume, although the pace and breadth of the global rollout of vaccinations remain uncertain,” the Bank of Canada said on Wednesday.
At the same time, “a broadbased decline in the U.S. exchange rate has contributed to a further appreciation of the Canadian dollar.”
The decision to once again acknowledge the exchange rate as an important variable was perhaps the most noteworthy development in the central bank's stance from its previous deliberations six weeks ago. Policy-makers tend to reference the dollar only when it's having a material effect on the economic outlook.
A stronger dollar isn't necessarily an impediment to overall growth when oil prices are rising, because the latter implies increased wealth from trade. But when commodity prices are subdued, as they have been until very recently, a higher exchange rate is a drag on growth, because exporters of services and manufactured goods make less on their sales and might even lose business, depending on the extent to which they rely on a weaker currency as a competitive advantage.
To be sure, any concern about the currency is probably marginal; one variable among an unusual number of forces that are contributing to what Macklem said will be a “choppy” return to economic stability.
“Canada's economic recovery will continue to require extraordinary monetary policy support,” the central bank noted.
The news that Health Canada approved the Pfizer Inc./ Biontech SE vaccine suggests the recovery could be stronger than the Bank of Canada was expecting, since in October it had assumed that mass vaccinations wouldn't crush the disease until the middle of 2022.
Yet large swaths of the country will spend Christmas in some version of lockdown, as provinces struggle to contain the second wave of infections. That means health and fiscal policy will exert the greatest influence on our economic prospects in the near term.
Stricter social-distancing rules “can be expected to weigh on growth in the first quarter of 2021 and contribute to a choppy trajectory until a vaccine is widely available,” the Bank of Canada said. “The federal government's recently announced measures should help maintain business and household incomes during this second wave of the pandemic and support the recovery.”
Bay Street mostly shrugged at the latest statement from the central bank. Veronica Clark, an economist at Citigroup Global Markets Inc., called it “decidedly neutral.” Arlene Kish, director of Canadian economics at IHS Markit Ltd., reminded her clients in a note that fiscal policy at this stage “will play a more pivotal role in the economic recovery.”
Still, the policy announcement will be remembered, even if it was light on news, since it will stand as senior deputy governor Carolyn Wilkins's final contribution to policy. Wednesday marked her final day at the Bank of Canada.
Wilkins, the most powerful woman in the central bank's history, played a leading role in the Bank of Canada's most aggressive deployment of monetary policy ever, dating back to March when policy-makers unloaded the arsenal to offset the economic shock of the COVID-19 pandemic.
Her efforts nearly earned her the top job. The transition from former governor Stephen Poloz this spring came down to a choice between Wilkins and Macklem, with Prime Minister Justin Trudeau opting for the more experienced candidate.
Even though the shock-and-awe campaign that Wilkins helped orchestrate has subsided, policy-makers continue to deploy historic levels of stimulus. The Bank of Canada reiterated that it would continue to buy Government of Canada bonds at a rate of about $4 billion per week to keep downward pressure on interest rates, and it restated that it would keep the benchmark lending rate pinned near zero until sometime in 2023.
Ultimately, Bank of Canada leaders care most about hitting their inflation target of two per cent. They noted that the inflation measures they follow to get a read on where prices are headed are all below two per cent, and that “considerable” economic slack is “expected to continue to weigh on inflation for some time.”
Canada's dollar has climbed to about US78 cents from around 76 cents at the end of October, when the central bank last reviewed its policies. The currency was a subject of consideration during those meetings, earning a mention in the Oct. 28 statement, and would have been one of the factors that went into the central bank's decision to add monetary stimulus by making an “extraordinary” promise to leave the benchmark rate near zero for more than two years.
The exchange rate also weighs on the central bank's inflation calculations, as it has implications for the cost of imported goods and services. In the current context, a stronger currency could act as another downward force on prices, adding to the challenge of getting overall price increases back to two per cent.
“The way I read the comment from the Bank of Canada is that there is nothing they can do for the dollar strength, because it is broad-based U.S. dollar depreciation,” said Charles St-arnaud, chief economist at Alberta Central. “With lower imported goods prices, we could see that contribution decline in the coming months, pushing inflation lower, maybe even negating some of the domestic pressures.”
News on the development of ... vaccines is providing reassurance ... although the pace and breadth of the global rollout of vaccinations remain uncertain.