Discussion and Analysis by Charles Porter:
Despite defying the dominant market opinion, and with inflation trailing well below a 2% target, the Bank of Canada raised their interest rate target by 25 basis points. This article analyses this move in the context of the global political economy and the viewpoint of the Bank of Canada.
Given the predictable effects upon the exchange rate, and the spill-over effects therein, a hike decision was forecast neither by our previous analysis, nor by the dominant market perception. An analysis prioritising a logic of exchange rates led the previous article, and market analysts alike, to a no-hike conclusion. Interestingly, despite the Bank claiming to give a privileged consideration to the power of the domestic currency, the foreseeable exchange rate effects appear to have been forgiven.
The overwhelming motivation for the interest rate hike from the Bank of Canada this afternoon was economic growth performance. Specifically, as we alluded to within our previous article, Gross Domestic Product (GDP) statistics released last Thursday guided the rate hike. As the second consecutive rate hike of 2017 to the tune of +0.25%, following a duration of 12 months fixed at 0.5%, the decision certainly leads momentum to sentiment of global economic recovery.
Intraday movements of Canadian Dollar currency pairs showed sharp volatility. In order to visualise and analyse this event, the intraday graph is provided and described below.
Figure One: Intraday movement of the Canadian Dollar (CAD) against the US Dollar (USD). The figure above shows a considerable strengthening of the CAD against the USD. CAD strength has been observed after the decision at 15:00 within most major currency pairs. The move against the Euro has been more moderate whilst markets eagerly await tomorrow’s ECB announcement.
The Canadian Dollar operates within a flexible, floating, exchange rate. Therefore, the inflow of ‘hot’ money taking advantage of the higher rate of interest and the differential between major currencies leads to an increase in the demand for CAD. Given that the supply of Dollars will be relatively fixed within the short run, in the absence of immediate monetary responses or forced currency sell-offs, the exchange rate appreciates in favour of the CAD.
Despite relinquishing control over the domestic currency via direct manipulation or pegging, the Bank of Canada does admit that considerable attention is paid to the exchange rate. They do so in order to preserve the international purchasing power of their Dollar and also to ensure that stable rates preserve the exporting competitiveness of the economy. Exports are an important part of the economy particularly given the economy’s exposure to commodities.
In fact, within the document explaining the Bank’s position on the exchange rate, it explicitly states that “the Bank is not indifferent to persistent currency movements”… specifically with regard to the spill-over effects upon “total demand and inflation”. This conclusion follows premises explaining the particular relevance of the external value of the currency, particularly with reference to the US Dollar. Therefore, it is unsurprising that markets and analysts alike did not expect the rate hike that today’s announcement brought. Consider the persistent and considerable appreciation of the Canadian Dollar over recent months:
Figure Two: An 8.1% appreciation of the CAD against the USD since mid-June may have threatened the competitiveness of Canadian exports. Increasing the internationally perceived price of Canadian exports (including the nationally important net-exporter status of commodities) threatens the future growth of the Canadian economy via the net exports channel.
As the explanation of Figure Two argues, the decision to raise interest rates and the concomitant strengthening of the CAD could be seen as short-sighted and harmful. If the decision to raise the target overnight rate was in response to “recent economic data”, as indeed it was, the longevity of optimistic economic data to which it responds could be threatened.
Moreover, the decision acknowledges that inflation is considerably “below the 2 per cent target”. By tightening loose monetary policy, thereby reducing the degree of monetary stimulus, inflation, ceteris paribus, will be subdued. Therefore, today’s rate hike was unanticipated due to the concerns that such a decision will increase the propensity for the strong growth to be undermined and weak inflation to be sustained or worsened.
This analysis may not ultimately manifest; both growth and inflation may pick up. However, Bank of Canada’s admonition over “a moderation of the pace of economic growth in the second half of 2017” suggests that it is an extant concern of theirs too. Ultimately, the effects of an unfavourably strong Canadian dollar may result in a deterioration of the national current account. Over the long-run, the current account deterioration effect could induce a reversal of the Canadian Dollar’s appreciation, unwinding yesterday’s post-announcement gains and the sustained appreciation over the past few months.