Bank of Canada Tracking Impact of Higher Rates, Stronger Loonie

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  • Policy makers ‘paying close attention’ to economic impacts
  • Context of rate hikes was stronger exports, business spending

Why the Bank of Canada Is Comfortable Hiking Rates

The Bank of Canada gave the strongest indication yet it is concerned about the Canadian dollar’s recent gains, with a top official saying policy makers will closely monitor the currency’s impact on the economy.

In the bank’s first public remarks since raising interest rates two weeks ago, Deputy Governor Timothy Lane spoke to a business audience in Saskatchewan where he outlined the factors that went into that decision -- what he called “context.” They included stronger business spending and recent gains in foreign sales that had been helped by the Canadian dollar’s weakening in recent years.

“We will be paying close attention to how the economy responds to both higher interest rates and the stronger Canadian dollar,” Lane said in a speech in Saskatoon, Saskatchewan.

The Canadian dollar had its biggest intraday decline since January as investors interpreted the speech as an effort to pare expectations on rate increases. Up until today, investors and economists had been split on whether the central bank will tighten for a third straight meeting in October. The Canadian dollar rose to its highest in more than two years after the Sept. 6 rate hike.

In addition to highlighting the currency’s strength, Lane also cautioned there are other considerations when it comes to higher interest rates, particularly their effects on indebted households.

“This was likely meant to temper expectations of future rate hikes that helped drive the loonie up nearly 2 cents against the U.S. dollar after the September 6th decision,” Brian DePratto, a senior economist at Toronto-Dominion Bank, said in a note to investors.

Canada’s currency weakened by 0.8 percent after Lane’s remarks to C$1.2295 per U.S. dollar at 3:04 p.m. Toronto time.

Governor Stephen Poloz is seeking a balance between bringing interest rates back to more normal levels amid the strongest growth spurt in more than a decade, without harming an economy that is only now beginning to fully emerge from an almost decade-long state of excess capacity.

The Canadian dollar’s gain of about 10 percent over the past four months is a potential drag on exports and business spending.

“Growth in Canada is becoming more broadly based and self-sustaining” including exports, business investment and rising imports of machinery and equipment, Lane said in the speech, which was focused on international trade. “It was in this context that the Bank of Canada decided, in July and again earlier this month, to raise our policy rate.”

Lane was even more definitive in response to a question after the speech. “As the Canadian dollar is strengthening, we are certainly watching that closely and will be taking that into account pretty strongly in making our decisions,” he said.

While Canada’s policy rate is still low compared to the so-called neutral level, Lane said the stance is “appropriate” given the risks in the economy including high household debt levels. The July tightening was the first since 2010, and the latest move restored the overnight benchmark to 1 percent where it was before cuts to deal with an oil shock in 2015.

Lane also said the outcome of North American Free Trade Agreement talks could have “important implications for the Canadian economy” that monetary policy may eventually need to consider. A protectionist shift during Nafta talks could lead to lower potential growth for the nation’s economy, he said.

Most of his prepared remarks touted the benefits of free trade, and suggested risks around rising global protectionism could tighten the movement of goods. “The possibility of a material protectionist shift -- particularly regarding the outcome of negotiations on possible changes to Nafta -- is a key source of uncertainty for Canada’s economic outlook,” Lane said.

Over the long run, free trade has created jobs, Lane said, and new barriers could curb Canada’s exports and potential economic growth. While technological innovation and trade have meant some workers are “left behind,” Lane said, policy makers should support workers in transition rather than seek to “turn back the clock.”

Still, Lane said the adjustment to the oil shock has been “complex” and the return of non-energy exports has been slower than expected, even after the country’s dollar weakened by as much as 25 percent.

It will take time to build new trade networks, Lane said. One positive sign is gains in imports of machinery and equipment, suggesting companies are investing again, he said.

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