Canadian Dollar, Interest Rate and Economic Growth

The Canadian dollar is back near parity, it’s been all over the place over the past few weeks, down to 0.92 and all the way up to 0.97 today.  Why the currency gyrations?:  First, we are in the middle of the silly season, there is little depth to the markets, second the market is looking for good news, even when it doesn’t exist, and finally oil price are on the war path again – around $81/bbl.  The Canadian dollar is heavily correlated to oil prices (around 90%).

 

I always worry when the Wall Street Journal starts having articles about Canada – and over the past few months the number of articles (rarely do they get their facts right) have been written – first our banking system, now its our taxation system with Canada: the Land of smaller Government.  First, insisting that Canadian corporate income tax 18% (don’t worry its not) then making the point that all budget cut initiative have been initiated by “Liberal” administrations), and finally, to say that Canada is the land of smaller government is a gross mischaracterization of Canada’s economic model.

Getting to economic data over the past few weeks, the numbers are far rosy than they were in the first and second quarter.  

(1)                                       Unemployment rose in June (up 12k), but it easy to forget that Canada has created more than a ¼ of million jobs over the past 9 months, which is massive),

(2)                                       Inflation is clearly tame, falling both in general and the core rate (1.7% and 1.8% respectively).  Inflation from foreign price is falling and will continue to fall for at least another year.  

(3)                                       Capacity utilization appears to be nearly full, which implies that Canadian companies will soon have to invest in plant and equipment (although uncertainty about the economy has slowed this process down).

(4)                                       Housing seems to have hit a speed bump.  After rising for the past 12 months, and now at a new peak, the Canadian market seems to be moving towards surplus capacity

Last week’s job report was poor, but then so many jobs were created in Canada over the past six months, it was to be expected.  This will be a problem for the Bank of Canada’s objective of further raising interest rates.  The dollar is not a component of the BoC’s interest rate fixing policy, but economic growth (and inflation) are.  Growth appears to have dropped off over the past few months, the Canadian short term rate now stand at 0.75%, and may rise further to 1.0% by the end of August, but in view of the slowing US economy, it would seem that the BoC’s offorts to raise rates are nearing the end.

 

Foreign investors’ interest in Canadian economy are dominated by the direction of the Canadian dollar, economic health and interest rate policy as barometer for their decision to invest in Canada or increase (or reduce) their holdings.

First, the BoC never takes the strength of the Canadian dollar in their interest rate setting process.  As far as the BoC is concerned, the strength of the currency is an output, over which they can have no lasting impact (someone should have told this to the SNB trying to hold the Swiss franc).  Inflation is still key factor, and Canada faces two different sources (more so than other economies), when natural resource prices rise, the Canadian dollar tends to rise – as such the inflation impact on Canada is initially mitigated, and Canada also faces inflation from the endogenous elements such as labor market and excess capacity (or the lack thereof).  Canada’s manufacturing base shrinks on an annual basis, accounting for nearly 1/3 of economic activity in the early ‘90s today it accounts for les than a ¼.  This shift is common to any advanced economies, but it poses problems when the BoC attempts to evaluated the level of spare capacity in the system. Canada’s various governments remain committed to cutting their operating deficits, both by raising taxes and by controlling expenditures.  

The current federal administration is minority conservative government, which will probably call the election in two years – facing a divided opposition (three parties), and remains committed to lower taxation and smaller government (all Canadian governments face the same rapid natural shrinkage of their labor force as a large number of functionaries are looking at retirement over the next 5 years).

Chart Porn: