The uncomfortable loonie

Many analysts have been calling for the Canadian dollar to fall to something like 85 cents (US) this year.  Instead, after flirting briefly with levels below 90 cents, the currency has rallied strongly in recent weeks, and today briefly traded above 94 cents, before slipping back a little.  Exporters, as well as the Bank of Canada, are reportedly "uncomfortable" with these developments.

Many people are attributing the sharp reversal to the rise in oil prices, as a result of the conflict in Iraq. That may be a contributing factor, but it can't be the whole story.  The loonie began to rally well before ISIS hit the front pages. It's more likely that markets are taking notice of the sharp rise in Canadian inflation over the past twelve months.  When Bank of Canada Governor Stephen Poloz took over the top job in mid-2013, he routinely expressed his fear that full-blown deflation might be on the horizon.  Instead, CPI has accelerated from 0.7% at this time last year to 2.3% currently, above the Bank's 2 percent target rate. This has inevitably led to speculation about when the Bank might have to start raising interest rates.

If this is indeed making Gov. Poloz uncomfortable, it's because he has no good options available to him. Cheap money has done little to revive the economy, which continues to wallow along, so raising rates to head off the rise in inflation is not a palatable choice.  With the Federal government sticking to its austerity program in order to unleash a wave of personal tax cuts just ahead of next year's election, there's no prospect of a fiscal boost to take some of the weight off of monetary policy.

The bounce in the exchange rate may help to reduce inflationary pressures very marginally, but it's likely that the next few months will see CPI stuck above the 2 percent target, while the weakness in the economy keeps the Bank twiddling its thumbs on the sidelines.  And all the while, personal debt will continue to hover at levels comparable to those seen in the US just before the financial crisis.  If you had Stephen Poloz's job, you'd be uncomfortable too.