The Bank of Canada's Indirection
30/09/09 20:01
Chris Lori and Ashraf Laidi
Webinar
Saturday Oct 3
Chris Lori Workshop
Kuala Lumpur
Oct 9-11
A good Article by Karl Schamotta, Market Analyst at Custom House Foreign Exchange
The Canadian dollar’s persistent strength continues to drive speculation that the Bank of Canada will intervene in the currency markets in an effort to support economic growth. The currency’s elevated value is already having a substantial deleterious effect on the Canadian economy, and fears are rising about whether the nascent economic recovery may be delayed as a result.
The Bank is specifically mandated to keep inflation within a target band. Because the general level of economic activity often predicates the inflation rate, the Bank is empowered to influence the currency’s value when it threatens to affect growth. However, Bank policymakers have frequently said that they see direct currency intervention as being futile, and prohibitively expensive. Therefore, while officials have repeatedly issued veiled threats against the currency’s rise over the last few months, the markets have routinely dismissed these threats as “jawboning” and have discounted any possibility of currency intervention. Because much of the Canadian dollar’s recent rise has been driven by speculative flows against the U.S. dollar, we also don’t see a strong likelihood of short-term intervention.
Saturday Oct 3
Chris Lori Workshop
Kuala Lumpur
Oct 9-11
A good Article by Karl Schamotta, Market Analyst at Custom House Foreign Exchange
The Canadian dollar’s persistent strength continues to drive speculation that the Bank of Canada will intervene in the currency markets in an effort to support economic growth. The currency’s elevated value is already having a substantial deleterious effect on the Canadian economy, and fears are rising about whether the nascent economic recovery may be delayed as a result.
The Bank is specifically mandated to keep inflation within a target band. Because the general level of economic activity often predicates the inflation rate, the Bank is empowered to influence the currency’s value when it threatens to affect growth. However, Bank policymakers have frequently said that they see direct currency intervention as being futile, and prohibitively expensive. Therefore, while officials have repeatedly issued veiled threats against the currency’s rise over the last few months, the markets have routinely dismissed these threats as “jawboning” and have discounted any possibility of currency intervention. Because much of the Canadian dollar’s recent rise has been driven by speculative flows against the U.S. dollar, we also don’t see a strong likelihood of short-term intervention.
Implementing direct currency intervention is relatively simple. The central bank sells Canadian dollar reserves and buys the currencies against which it wishes to have leverage. By selling Canadian dollars, the Bank increases the supply of Canadian money available to the currency markets, and this slows price appreciation. A number of methods are used to “sterilize” these interventions so that they do not have an undue effect on interest rates or money supply.
This form of intervention has a chequered history. Most famously, the Bank of England’s efforts to support the Sterling in 1992 led to abject failure as speculators bet the Bank would not have the resources and determination to succeed. George Soros is believed to have pocketed $1.1 billion in the process. On many other occasions, markets have effectively ignored intervention efforts, taking currencies to new levels and causing massive losses for central banks. Successful initiatives have generally been components of longstanding intervention policies or have been paired with capital controls.
However, direct currency intervention is only one of the tools available to the Bank. Keeping interest rates low and downplaying expectations of hikes in the future is very simple, and highly effective. Another method involves creating new money, and is often known as “quantitative easing.” Both methods carry inflationary risks, and are generally only performed when central banks perceive enough slack in the economy.
In an effort to stem deflationary pressures and stimulate growth, the Bank has committed to keeping interest rates low through the middle of 2010 and possibly beyond if economic conditions warrant. In looking at statistics collected over the last year by the Bank of Canada, M1+ (gross) money supply has risen by 15.4% over the last year, while the economy has contracted -6.5% and the trade balance has gone down to -6.3%.
In short, the Bank’s deflation-fighting measures amount to indirect long-term intervention. The Bank’s actions are ultimately geared towards stimulating domestic economic growth, but keeping rates low and keeping the printing presses rolling should have a depreciating effect on the currency in the long term. Whether the Bank of Canada can outpace similar programmes being conducted by the Federal Reserve is another question entirely, and one that will determine the long-run value of the Canadian dollar.
Karl Schamotta, Custom House