Rising loonie could spark interest rate cut

(October 8, 2003) The Canadian dollar hit a seven-year high against its U.S. counterpart yesterday, leading to increased speculation the Bank of Canada will move to reduce interest rates next week in an effort to keep the soaring loonie under control.

The loonie opened at 75.08 cents US Wednesday morning, an 18% increase since the beginning of the year. The central bank’s next interest rate announcement is scheduled for October 15, with the key overnight lending rate currently at 2.75%. The Bank of Canada has cut rates by 50 basis points since July.

“The threat of a move to 80 cents [by the Canadian dollar] will spur the Bank of Canada into another 75 basis points of rate cuts over the next six to nine months,” says CIBC World Markets in an online commentary.

Scotiabank says the market is confused about what the central bank will do next week, with few clues being offered, save for the rising loonie. Scotiabank expects a cut of at least 25 basis points, with a further reduction in December, the final interest rate announcement of the year.

But others aren’t so sure a rate cut is in the cards. “The most likely outcome is still that the U.S. economy will continue to firm up, that the path of core inflation will unfold more in line with the bank’s forecast, and that the Canadian dollar’s gains will remain limited,” says TD economist Marc Levesque. That scenario suggests the bank will stand pat next week. Still, the odds of a rate cut have increased substantially, he concedes.

There’s also a divergence of opinion on the outlook for the loonie. While economists at RBC Capital Markets and CIBC World Markets believe an 80-cent loonie is a possibility, BMO Nesbitt Burns predicts the Canadian dollar to stabilize and remain in the 75-cent US range.

However, Conference Board of Canada chief economist Paul Darby expects the loonie’s rally to fade, forecasting a 71- or 72-cent dollar by the end of 2004.

Some experts contend that the loonie’s rapid ascent is bad news for the Canadian economy, which is heavily dependent on exports to the U.S.

“There is a misconception that a stronger currency means a stronger economy,” says Canadian Auto Workers economist Jim Stanford. “But in Canada’s case, the exact opposite tends to be true. If the dollar is sustained at current levels or higher, Canada’s economy will inevitably start to contract.”

Stanford says the Bank of Canada should reduce interest rates to bring the dollar down to around 72 cents, a level he believes will make Canadian goods competitive again.

Filed by Doug Watt, Advisor.ca, dwatt@advisor.ca