The Canadian dollar's surge has become such a serious issue for the economy that Bank of Canada Governor Mark Carney has been pushed into doing something he almost never does: Talk about the currency.
In unusually direct language, the central bank said yesterday that the loonie's "unprecedentedly rapid rise" in the past month could "fully offset" early signs of economic recovery if the surge persists.
The comment came in the Bank of Canada's latest interest rate announcement, which left the benchmark lending rate at an effective floor of 0.25 per cent, a level at which policy makers had already said the overnight target will likely stay until the middle of next year.
Investors and economists took note of the currency comment because Mr. Carney, a former investment banker, so rarely broaches foreign exchange rates, a sensitive subject because traders so often make bets based on the comments of economic officials.
The loonie's jump above 90 U.S. cents would have been difficult to ignore in any assessment of Canada's trade-dependent economy. Still, many analysts were surprised that policy makers went as far as suggesting the exchange rate could prolong the recession.
The Bank of Canada's prediction could cause some of those traders to increase odds of Mr. Carney intervening in foreign exchange markets, which would tame the currency's more than 10-per-cent rise since the end of April. At the same time, a greater focus on the dollar will raise questions about how far Mr. Carney is prepared to go to reduce currency risk in Canada's economic outlook and whether any intervention would be successful.
"They bought themselves some time on the currency side," said Matthew Strauss, senior currency strategist at RBC Dominion Securities in Toronto. "The currency is clearly back on their radar screen. The question is what will they do?"
More than the level, the Bank of Canada is most troubled by the speed of the dollar's rise.
While Canadian exporters prefer a currency that trades at a discount against the U.S. dollar, what really drives them mad is the volatility. Rapid change like that throws off hedging strategies and makes it difficult to set profitable prices.
Nuance is everything for currency traders, so even statements of the obvious will get their attention if those utterances are at all different from previous comments.
Mr. Carney last weighed into foreign exchange markets in October, after the value of the Canadian dollar had collapsed by almost 20 per cent amid the worst of the financial crisis.
He observed at the press conference that the volatility in currency markets at the time was "extreme" and warned that he was "watching developments in foreign exchange markets very closely," a shift in rhetoric that served as a warning shot to speculators.
The Bank of Canada didn't intervene then, nor is it likely to do so any time soon.
"Where are they on the escalation ladder, with benign neglect being zero and intervention tomorrow being 10? I would say two or three," said Marc Chandler, head of global currency strategy and Brown Brothers Harriman in New York.
The central bank hasn't intervened in currency markets since 1998.
Policy makers have generally concluded that picking fights with hedge funds is generally a losing proposition, said Chuck Freedman, a scholar in residence at Carleton University in Ottawa and former deputy governor at the Bank of Canada.
That doesn't mean Mr. Carney wouldn't tap Canada's reserves to buy U.S. dollars in a bid to counter the speculative pressure on the exchange rate, Mr. Freedman said, noting New Zealand's central bank has said it is prepared to intervene on that basis.
"The way the bank approached this in my day was to think about what's causing the appreciation," Mr. Freedman said. "If the market is being driven by economic factors, you don't necessarily want to react because that's probably what ought to be happening."
The Bank of Canada said yesterday that the forces driving the currency higher are a both fundamental and speculative, citing higher commodity prices and the retreat from the U.S. dollar as the reasons for the loonie's rise.
Economists said Mr. Carney would seek to "talk down" the Canadian dollar before real intervention.
That might have begun yesterday. With the currency becoming such a dominant theme in discussions about Canada's prospects, the central bank had to acknowledge that the loonie's ascent is posing problems or risks making the situation worse.
"The dollar would have rallied if they had said nothing," Mr. Chandler said. "The market would have interpreted nothing as the Bank of Canada having no concern at all."
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Potential arsenal
With only $40-billion in foreign currency reserves, the Bank of Canada lacks the ammunition to bring about a fundamental shift in the dollar's value. But Governor Mark Carney might slow the loonie's ascent by making speculators think twice, because he could cause them to lose money in the short term. Here's how:
Step one: Verbal intervention. Mr. Carney uses more aggressive rhetoric, causing some traders to back off in case he backs his words with real cash.
Step two: He uses reserves to buy U.S. dollars. This hasn't been tried since 1998 because policy makers concluded it doesn't work. Still, central banks in Australia and New Zealand keep intervention in their arsenals to ease volatility.
Step three: Quantitative easing. One reason Canada looks good to investors is that even with its target rate at the lowest possible, the central bank isn't planning to ease monetary conditions by creating money to buy assets, like the Federal Reserve and the Bank of England. If it did, some investors could lose interest in Canada.
Kevin Carmichael