Smoke and mirrors on interest rates at the Bank of Canada

For their sixth meeting in a row now, the Bank of Canada has decided to leave interest rates unchanged.

Some of suggested this latest press release suggests  higher rates ahead, and the stronger dollar that comes with it. I think this is flawed and superficial analysis.

Let’s consider the press release with the awareness that all central bankers are Keynsian-merchantilists.

The possibility of greater momentum in household borrowing and spending in Canada represents an upside risk to inflation. On the other hand, the persistent strength of the Canadian dollar could create even greater headwinds for the Canadian economy, putting additional downward pressure on inflation through weaker-than-expected net exports and larger declines in import prices.

So what would curb household borrowing and spending in Canada? Higher interest rates of course. But then that would create a stronger Canadian dollar, which the BoC regards as hazardous because it would hurt exports. To me, this does not suggest higher interest rates from the BoC anytime soon.

Reflecting all of these factors, the Bank has decided to maintain the target for the overnight rate at 1 per cent. To the extent that the expansion continues and the current material excess supply in the economy is gradually absorbed, some of the considerable monetary policy stimulus currently in place will be eventually withdrawn, consistent with achieving the 2 per cent inflation target. Such reduction would need to be carefully considered.

Now this sounds like they are leaning towards raising interest rates. Or does it? Earlier in the press release, they say the following:

While underlying inflation is relatively subdued, the Bank expects that high energy prices and changes in provincial indirect taxes will keep total CPI inflation above 3 per cent in the short term. Total CPI inflation is expected to converge with core inflation at 2 per cent by the middle of 2012 as excess supply in the economy is gradually absorbed, labour compensation growth stays modest, productivity recovers and inflation expectations remain well-anchored.

Here is where we get to the “smoke and mirrors.”

They were just quoted saying they would want to withdraw the monetary stimulus to aim for the 2% inflation target.

But in this last quoted paragraph, they just said that they expected inflation to hit 2% without raising interesting rates. So … what the heck is this all about? Basically, there is no chance interest rates will be going up any time soon.

The reality is this — Carney will not allow the Canadian dollar to appreciate too significantly relative to currency of this country’s primary consumer, which is America.

One must remember that central bankers behind major currencies work together — the key idea is to have major currencies devalue at roughly a steady rate vis-a-vis each other. It is not a counter-example to refer to hyperinflation in Zimbabwe or a like event, because that is a tiny country that means little to the world economy in the grand scheme of things.  The Canadian dollar will not strengthen dramatically against the US dollar, or any other major currency.

Why not? If you are a central banker, you have two conflicting goals:

For importers, you want a strong dollar, so that you can buy foreign goods more cheaply.

If you are an exporter, you favor a weak dollar, so that you can sell more goods to foreigners.

Exporters have traditionally been a more focused and successful interest group than the mass of faceless importers — the exporters are visible and politically active, but the importers are literally… everyone else. Their influence is spread out like too little peanut butter spread over too much bread. Therefore the tendency is always for a steady level of currency depreciation. For the BoC, that is a 2% inflation target.

Because of these conflicting agendas, the central bank behind a major currency cannot allow that currency to appreciate or depreciate too significantly relative to any other major currency. It is the classic problem with central planning — how do you decide what the magic number is? The level of depreciation must be just enough to keep everyone happy — or at least minimize their relative unhappiness.

To take out price distortions, one can consider how all currencies are down significantly from where they were one year ago, in terms of gold. The Canadian dollar is down 12%. So while it has lost purchasing power in terms of gold, it has gained purchasing power relative to the USD, which is down 20% in the last year. The euro and the yen have fared relatively better than the Canadian dollar (down 8% and 11% respectively, in terms of gold), and the American dollar has fared relatively worse. The important point is that they are all down in terms of gold.

This is to be expected. Although the CDN may rise or fall a bit relative to one major currency or another, depreciation of the Canadian dollar will continue relative to gold until Economic Judgment Day comes and Great Depression II hits us. Economic Judgment Day until the big American banks start to lend, and the Federal Reserve is forced to hike interest rates. Until then, Canadian currency is just another depreciating currency in a world of depreciating currencies.