Quantcast
Last updated on April 18, 2014 at 17:24 EDT

Why the Bank of Canada should not Take Aim at Canada’s “Overvalued” Dollar: C.D. Howe Institute

June 25, 2013

TORONTO, June 25, 2013 /CNW/ – A confluence of factors promises to put
pressure on the new Bank of Canada governor to direct monetary policy
at fixing Canada’s so-called “overvalued” currency, according to a
report released today by the C.D. Howe Institute. But in “The Seductive
Myth of Canada’s “Overvalued” Dollar,” author Christopher Ragan
provides two strong arguments against doing so: the importance of the
Bank’s focus on inflation, and the weakness of the “overvalued” dollar
argument.

The Canadian dollar has been close to par with the US dollar for the
past few years, and many observers claim that at this level it is
substantially “overvalued.” Meanwhile, Canadian exports have performed
quite poorly since 2008 and many see the new governor of the Bank of
Canada, Stephen Poloz, as a natural cheerleader for Canadian exports
due to his past as head of Export Development Canada, a
federal-government-owned export-promotion agency.

These facts can easily be woven together to produce a seductively simple
scenario in which Governor Poloz delays raising interest rates, or even
begins reducing them, in an effort to weaken the Canadian dollar, notes
Ragan. Such a policy approach would be misguided, he says, and the bank
will need to make two central arguments to avoid it.

First, many people will need to be reminded that central banks have but
one policy instrument under their control: the setting of a short-term
interest rate. And with only a single instrument, monetary policy can
have only a single target. Central banks choosing to target the rate of
inflation must therefore accept a freely fluctuating exchange rate.

Second, the view that the dollar is overvalued is on shaky ground. It
rests on the notion that international trade will eventually lead
prices for products in different countries to converge, he says. This
theory of purchasing power parity (PPP) suggests that the “right” value
for the Canadian dollar is about 88 US cents. However, most of the
products purchased by consumers are services that cannot be traded
across international boundaries. Realistically speaking, no market
force will bring the prices of non-traded services into equality across
countries, thus greatly weakening the theory of purchasing power
parity.

“It is more sensible to view the forces of demand and supply in the
foreign-exchange markets as determining the “right” value of any freely
floating currency. It makes little sense to think of such currencies as
ever being “overvalued” or “undervalued,” concludes Ragan.

For the report go to: http://www.cdhowe.org/the-seductive-myth-of-canadas-overvalued-dollar/22121

SOURCE C.D. Howe Institute


Source: PR Newswire