VANCOUVER - The Bank of Canada is now focused on the rapid fall on the U.S. dollar in recent days and what impact it will have on the Canadian economy, bank governor David Dodge said Tuesday.
While Canada's money markets are on the way to recovery following this summer's credit crunch, Dodge suggested the central bank may need to leave its key interest rate where it is at its next scheduled announcement Oct. 16.
Before the credit crunch emerged in August, sparked by soaring defaults of payments on subprime mortgages in the United States, the Bank of Canada had been widely expected to raise its rates to dampen inflation.
However, Canada's central bank ended up keeping its short-term rate unchanged at 4.5 per per cent at its Sept. 5 meeting. Since then, the U.S. central bank has lowered its comparable rates by an unusually large half-point, a key factor that has driven down the price of the U.S. dollar relative to other currencies.
"In recent days, the Canadian dollar has moved sharply above the trading range assumed (by the bank in July) and we are now having to examine the causes of this strengthening, should it persist,'' Dodge said in a speech Tuesday to the Vancouver Board of Trade.
"In addition, there is uncertainty about the extent and duration of the tightening of credit conditions in Canada and, hence, about the tempering effect this will have on the growth of domestic demand.
"Gauging the effects ... will be one of the bank's most pressing tasks over the coming months.''
Last week, the Canadian dollar reached parity with the U.S. dollar for the first time since late 1976. On Tuesday, the loonie moved down 0.19 cent at 99.64 cents US after going as high as 99.98 cents US. The currency had risen above par in each session since last Thursday -- but has not yet closed above that threshold
Dodge said what the bank will do next will take time to figure out.
"What we have to do is analyze: is this a temporary movement, is this likely to be sustained and what are the roots causes? This is what we'll do leading up to the next policy report,'' Dodge told reporters after the speech.
"We are seeing depreciation of the U.S. dollar that has different implications for monetary policy.''
Dodge added the immediate impact on inflation of the stronger Canadian dollar is "relatively muted.''
"The impact of the exchange rate on consumer prices is relatively small and the lags are relatively long,'' Dodge said, adding that while price impacts are felt sooner on products such as fruits and vegetables, most other prices change over a much longer period of time.
Explaining the nature of the credit crisis that took hold in August, Dodge said central bankers hadn't fully appreciated the impact of easy credit available at low interest rates -- although they had been concerned.
He said the situation began going off the rails because, with world interest rates low, investors began looking for higher returns even if it meant taking on added risks.
In turn, lenders sought comfort by opting to securitize high risk loans by bundling them into instruments backed by cash flows generated from the loan repayments. This, said Dodge, had the effect of making high risk loans appear to be low risk.
"It seems to me that in recent years, central bankers may have not fully appreciated just how much the increase in securitization represented an easing of credit conditions,'' he said. "Loans were being shifted off balance sheets, allowing more loans to be made.''
Alan Greenspan, the former chairman of the Federal Reserve, recently acknowledged publicly that he had not foreseen the extent of the impact of relaxed lending policies to house buyers with poor credit ratings.
Dodge reiterated his message he gave in London, England, two weeks ago that the events that led up to the credit crunch sparked by the subprime mortgage defaults highlighted the need for improved transparency in the money markets and more publicly available information on the nature of debt.
He acknowledged that there will be a temptation among governments to try and legislate market behaviour, such as making credit rating agencies more transparent in their assessment of highly structured products, but cautioned against it, saying market forces will go a long way to resolving the problem.
"There will be undoubtedly be calls for tighter government regulation for credit-rating agencies. But I would caution against any knee-jerk regulatory response.''
Given the chaos of this summer's markets, Dodge said credit agencies that fail to assess the true level of risk will find themselves with fewer clients.
Dodge also said the Bank of Canada's decision in August to increase liquidity has had the desired effect.
"All told, our actions were effective in helping to improve the functioning of the overnight money market,'' he said. "And while it is true that many term money market spreads remain abnormally wide, the market is functioning.''
Should the spread persist, Dodge said it would have the same impact as an interest rate increase by the central bank.
