Why the Bank of Canada should not Take Aim at Canada's "Overvalued" Dollar: C.D. Howe Institute

Jun 25, 2013, 11:26 ET from C.D. Howe Institute

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