Given all the bad economic news floating around, financial market observers are increasingly convinced the Bank of Canada will cut interest rates at its next announcement, this Wednesday. In fact, a rate cut is now the odds-on favourite.
And while many Canadians may look forward to even lower borrowing costs, a growing number of economists — including those at the major banks — are saying another rate cut could throw the Canadian dollar into a tailspin, if it isn’t in one already.
Bank of Canada governor Stephen Poloz is in a tight spot, with neither an interest rate cut nor a rate hike offering the right results. (Canadian Press photo)
An interest rate cut usually reduces the attractiveness of a currency to global traders, causing it to fall. Economists are saying Canada’s currency has already fallen far enough.
“Last year, when the BoC surprised markets with a rate cut, the loonie was 3 per cent overvalued against its long term fundamentals. One year later, the CAD is already undervalued 16 per cent,” NBF chief economist Stefane Marion wrote.
Economists have previously estimated that price parity for the Canadian dollar is around 84 cents U.S., meaning that is what the loonie would have to be worth for prices to be the same in the U.S. and Canada. The loonie has fallen 5.3 per cent against the U.S. dollar just in the few weeks since the start of the year, and was trading at 68.7 cents U.S. on Monday afternoon.
“The unprecedented pace of [the loonie’s] decline risks an even larger hit to growth by shocking household confidence,” CIBC Capital Markets chief economist Avery Shenfeld wrote. “In that sense, a rate cut would be playing with fire.”
Shenfeld argued that “screaming headlines are overstating the implications for consumers,” but warned the impact could be real even if consumers are overreacting.
“These reports could have real implications for consumption, even of domestic goods, if Canadians judge every drop in the loonie as a sign of impending economic doom.”
An excessively low loonie could be bad even for exporters — the one group that’s supposed to benefit from a low dollar. NBF’s Marion notes that prices of industrial machinery — 73 per cent of which are imported — have jumped to a record high.
“This is bound to complicate Canada’s transition to a less energy-intensive economy,” he wrote.
But in essence, economists say, the falling loonie has already done what an interest rate cut is meant to accomplish — it has boosted Canada’s economy, by making Canadian exports more competitive in the global marketplace.
Bank Of Canada Between A Rock And A Hard Place
“The rapid-fire decline in the loonie is probably the strongest argument against the Bank of Canada cutting rates next week,” BMO chief economist Doug Porter wrote.
Porter noted that usually a central bank raises interest rates when its currency falls too far, as the Bank of Canada did in 1998, when the loonie fell 10 per cent in a six-month period.
But with a recession in Western Canada and Canadian household debt levels at record highs, thanks to high house prices and large mortgages, raising interest rates is likely not an option for the bank.
That puts the Bank of Canada in a tight spot, with neither a rate cut nor a rate hike offering the right results. And with so much uncertainty in the markets this month, many of the bank economists say Governor Stephen Poloz should stand pat this week.
It would be better for the bank “to keep its powder dry this month and act, if need be, after the next federal budget,” when we will know just how large the Liberal government’s stimulus spending plans will be, NBF’s Marion suggested.