The Bank of Canada’s Phantom Rate Cut

A little more than a year ago, the Bank of Canada (BoC) was notable for being one of the few banks in the developed world to take a hawkish stance on the future direction of interest rates. But the central bank has since abandoned an upward rate bias for a decidedly dovish posture, and its overnight rate remains at 1 percent, where it’s been since late 2010.

Unfortunately, the BoC’s policymakers are largely constrained from either raising or lowering this key short-term rate any time soon. Though inflation is at worrisome lows, a rate cut would simply spur greater borrowing from consumers at a time when many economists are already concerned about record levels of household debt and the prospect of a real estate bubble. And raising rates would remove liquidity from an anemic economy before it shifts toward new areas of growth.

So what does a central bank do when it’s largely precluded from taking action? Well, its outlook still has the ability to move markets, and jawboning can often help achieve policy ends in the absence of actual rate changes.

BoC Governor Stephen Poloz is focused on helping the economy shift from slackening domestic demand to growth driven by exports and business investment. In its latest statement, however, the bank noted that non-commodity exports “continue to disappoint,” while business investment, though up from prior lows, is recovering “more slowly than anticipated.”

Of course, improvement in the latter is likely contingent upon the former, and until the US and other major trading partners start to produce consistently strong economic growth, the BoC’s best bet for boosting export activity is to engineer a sustained decline in the currency.

To be sure, the Canadian dollar has already suffered a fall. After trading above parity with the US dollar for much of 2011 and 2012, the loonie sold off in earnest earlier this year, dropping below that key threshold in mid-February. The Canadian dollar currently trades at a two-year low near USD0.94, down about 7.8 percent from its trailing-year high.

At the same time, unlike his predecessor Mark Carney, who regularly cited the “persistently strong” exchange rate in the bank’s interest rate announcements, Poloz has publicly assumed the role of a more traditional central banker who’s narrowly fixated on inflation, declaring the bank’s inflation target as “sacrosanct.”

But that doesn’t mean Poloz isn’t privately cheering a decline in the currency. After all, prior to helming the BoC, he headed Export Development Canada, the government’s export credit agency. As such, he’s keenly aware of how the loonie’s relative strength until recently has likely undermined the country’s export sector.

But rather than overtly address the exchange rate, the bank’s newfound dovishness, which implies the possibility of a rate cut, could help push the currency lower. That’s what economists with CIBC World Markets term a “phantom rate cut,” which is one that’s merely hinted at, but never actually delivered. In a similar manner, they recall that the bank previously warned about a rate hike that never came to pass.

Because of that as well as other weakening fundamentals, some economists have dramatically lowered their forecasts for the Canadian dollar, including Goldman Sachs, which predicts the currency will trade near USD0.88 next year. That attention-getting forecast is far gloomier than the average forecast, which according to Bloomberg shows the currency continuing to trade near its current level through next year.

A weakening Canadian dollar may be a dispiriting development for US investors who enjoyed having growth and income from Canadian stocks enhanced by a strong loonie. But it’s an absolutely essential development for the country’s economy to get back on track, and that should ultimately be a good thing for our investments.