The Bank of Canada’s Interest Rate Dilemma

The Bank of Canada has revised upwards by a full percentage point, its prediction for expansion in the U.S. economy. The Bank of Canada now expects the U.S. economy to grow by 3.2 percent, while the Bank’s forecast for the global economy is for growth in the region of four percent. Canada’s economy on the other hand, will increase by only 2.4 percent in 2011 and 2.8 percent next year according to the latest estimates from the Bank of Canada.

The reason for Canada’s relatively weak showing? Based on comments Bank of Canada Governor Mark Carney made during an interview from the World Economic Forum in Davos, Switzerland, the economy is being pressured by an appreciating currency and a “competiveness problem”.

The Canadian dollar – or the “loonie” as it is nicknamed – has appreciated considerably against both the U.S. dollar and the euro over the past two years. Against the dollar, the loonie gained sixteen percent in 2009 and another 5.5 percent in 2010 and Canadian exporters fear a decline in sales as traditional markets seek lower-cost alternatives from manufactures with a more favorable rate of exchange.

But this is only part of the story according to Carney. The Central Bank Governor also places blame on the mixed results Canadian firms have had with respect to productivity levels. Statistics from the Bank of Canada show that per unit labor costs in Canada increased by thirty-one percent compared to the U.S. over the past five years. Part of this increase is due to the appreciation of the Canadian dollar but fully one-third of the extra labor charge can be tied to the lower productivity of the Canadian workforce. This combination of low productivity relative to other exporting nations, together with a stronger currency, threatens to further erode the competiveness of goods produced in Canada for sale abroad.

Canada’s commodity exports on the other hand, appear to be entering a new growth stage. With demand returning to the global markets and extending commodity prices, Canada is well-positioned to take advantage. Canada is the world’s largest exporter of potash; a necessary ingredient in fertilizers that is highly in demand in China and will be imported in ever-greater amounts as China’s agriculture sector expands in the coming years. Canada is also a leading provider of energy with some of the planet’s largest crude oil and natural gas deposits.

The downside of commodity exports however, is that these resources are priced in U.S. dollars. This means that with each uptick in the value of the loonie against the greenback, the real return declines.

The other challenge the Canadian economy faces over the next few months is the prospect of rising consumer prices at home. Recent data indicates that prices jumped 2.4 percent in December year-over-year after gaining 2.0 percent in November. The typical response by a central bank looking to hold prices in check is to hike interest rates but herein lies the dilemma – raising interest rates – especially at a time when the U.S. is expected to maintain its ultra-low benchmark lending rate – will likely further boost demand for the loonie.

Canada’s current overnight rate of one percent already offers a 0.75 percent premium over the U.S. rate; a fact not lost on investors searching for yields and safety of funds. On January 18th, the Bank of Canada addressed the issue of interest rates and the value of the currency saying that all factors would be “carefully” considered before any interest rate decision.

However, some analysts believe the Bank of Canada’s decision will be made easier in the coming months by market conditions they expect will lead to a pullback in the value of the Canadian dollar over the course of the year. If the loonie eases its pace of appreciation, this will provide the Bank an opportunity to raise interest rates to contain prices at home without compromising exports by pushing the loonie higher.

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