I tip my hat to anyone who predicted a year ago the Canadian dollar would break through U.S. dollar parity. I didn’t see it coming, and I don’t know of anyone on the Street who had it in their forecast. Having failed to predict it, however, most forecasters are now failing to worry about it. Even those who believe Canadian dollar strength will persist seem pretty relaxed about its consequences, pointing out that the currency’s been appreciating for five years now and the economy’s done just fine.
I think that’s a dangerously sanguine attitude. There are at least five reasons to expect that the loonie’s run-up this year will have a far greater impact on the Canadian economy in the year ahead than anything we’ve seen this far through this cycle.
First, the size and speed of the exchange rate move have been extreme. The Canadian dollar bought just 85¢US in early March of ’07. Even after the recent correction from US$1.10, we’re still talking about a nearly 20% rise in less than a year. That’s by far the biggest such appreciation in at least five decades.
Second, it’s not like we’re coming from a particularly cheap level. That 85¢US mark was already 37% above the 2002 low, and above most economists’ estimates of fair value. And each incremental cent up here has an outsized impact. (The effects are “non-linear,” in the jargon.) That’s in part because an overvalued Canadian dollar brings U.S. competition into the mix — it now makes sense for Canadians to buy cars, clothes, books and much else in the States, forcing Canadian retailers to slash prices to retain customers. (How many “strong dollar” discounts did we see when the loonie went from 65¢ to 75¢?) Now, economic models don’t handle non-linearity well, which may explain the complacency out there. But if reality doesn’t conform to the models, it’s the models that need re-evaluating, not reality.
Third, we can no longer make the case that the Canadian dollar has gone up in line with higher prices for the commodities we export. The Bank of Canada’s commodity price index, which is weighted in line with Canadian production, is no higher today than at its peak two years ago — when the dollar was 20% cheaper. Yes, oil and gold have gone up, but natural gas, base metal and lumber prices have not.
Fourth, the world may spin faster these days, leaving the lag between currency move and economic effect probably shorter than the “up to three years” we used to think it was. But human nature being what it is, the full impact of a moving exchange rate on consumer and business behaviour is not, and will never be, instantaneous. With the dollar’s spike so fresh, absence of evidence is not evidence of absence.
Fifth, and perhaps most importantly, the U.S. economy is in trouble. Real domestic demand grew at a 3.2% average annual pace between 2003 and 2006. Our estimate for this year is 1.8%; our forecast for next year is 0.4%, as the housing and credit bubbles deflate. The United States still buys fully 25% of Canada’s total gross domestic product; U.S. demand will always matter. And there are non-linearities here as well. Weaker demand implies greater cost sensitivity among U.S. customers, with the least competitive suppliers hit disproportionately hard. With the Canadian dollar up at these levels, many of those suppliers are likely Canadian, and may not be suppliers for long. Yes, Canadian manufacturers have been crying wolf on the currency for years — but remember, in the fable, the wolf does show up in the end.
Summing it up, I think the exchange rate is going to play a primary role in defying widespread expectations of a resilient Canadian economy in 2008. Both economic growth and core inflation are likely to fall well below 2% in the coming year.
I would be even more bearish on Canada’s near-term economic prospects — even suggesting we might follow the U.S. into recession — were Canadian policy-makers not in great position to provide some offset. I expect inflation to fall well below the Bank of Canada’s 2% target in early 2008, even absent any oil price relief, as goods prices fall to narrow the gap with U.S. prices. That should leave the central bank free to aggressively address any weakening in Canadian growth. I expect it to use that freedom in cutting the overnight rate target to 3% by late 2008, a further 125 basis points of easing following December’s initial cut. And I expect the easing to work in stimulating demand, in likely contrast to the situation in the United States, where the financial system’s greater problems will likely leave the Fed “pushing on a string” in its bid to reinvigorate the economy. Canada’s fiscal position is also superior, with a decade’s worth of federal surpluses providing room to spend more and tax less if need be.
Furthermore, it’s a good thing those policy levers are available, because I don’t think we’ll be getting any relief from the currency itself in the year ahead. To be sure, the Canadian dollar looks overvalued near parity with the U.S. dollar, prompting a steady outflow of funds — with Canadian consumers and businesses needing to swap loonies for greenbacks to buy everything from American books to American banks. But there should be plenty of investors with greenbacks to sell, as U.S. rates fall, the economy slumps, and foreign central banks play chicken with their trillions of dollars in devalued U.S. debt. From my lens, it will be difficult for the Canadian dollar to fall far against an already-falling U.S. dollar, and difficult for the Canadian dollar to rise against a wall of shoppers lined up at the border.
This analysis, and the humbling experience of calling foreign exchange markets both this past year and previously, leave me to conclude that the best forecast of the exchange rate a year out is probably the one we have now.
David Wolf is vice-president, head of Canadian economics and chief strategist at Merrill Lynch Canada Inc.