Financial Post With Files From Reuters · Mar. 28, 2011
In what one analyst described as an "unambiguously bullish message for the Canadian dollar," the governor of the Bank of Canada says the global commodity boom is here to stay and countries should be prepared to deal with it in the time-honoured fashion - with higher interest rates.
While Mark Carney directed his message mainly to Latin American countries which are grappling with a surge in capital and inflation brought on by booming commodity prices, Douglas Porter, deputy chief economist at BMO Capital Markets, said his comments also hold implications for Canada.
"I would say that this speech suggests we should begin preparing for higher rates and an even stronger Canadian dollar, and soon," Mr. Porter said on Sunday. "I thought it was an unambiguously bullish message for the Canadian dollar."
In his speech, Mr. Carney said while supply disruptions and speculative pressures have contributed to higher commodity prices, rapid urbanization in emerging markets is underpinning the commodity boom and that process can be expected to continue for decades.
"Even though history teaches that all booms are finite, this one could go on for some time," Mr. Carney told the annual meeting of the InterAmerican Development Bank in Calgary on Saturday.
Against such a backdrop, countries must be prepared to deal with higher commodity prices over the longer term.
"Everything else being equal, higher commodity prices usually necessitate higher policy interest rates," Mr. Carney said. "The degree of the policy response depends on many factors, including the reasons behind the price increases, the expected persistence of the shock, and whether a country is a net exporter."
Many emerging countries have been dealing with the commodity price shock with various capital controls such as taxes on foreign inflows and avoiding raising interest rates in a bid to keep their currencies from rising and choking off export growth.
In a panel discussion on Saturday, Uruguayan central bank chief Mario Bergara said "monetary policy is not enough."
But Mr. Carney appeared unsettled by the view. "Can I jump in on this? I'm a little nervous where we are headed," Mr. Carney said. "Monetary policy has to deal with inflationary pressures, first and foremost," he said.
He warned that misguided policies in emerging markets for dealing with high inflation and a flood of capital could lead to financial instability and weak global economic growth.
"That's where one can make pretty big mistakes and delay too much, both on the monetary side, or on the pretty fundamental structural reforms," he said.
As he has in the past, Mr. Carney said a flexible exchange rate can help offset the inflationary impact from rising commodity prices and capital flows.
"To the extent that the nominal exchange rate responds, it helps offset the expansionary effect of the increase in investment, and gives price signals to the production sector for labour and capital to shift to the areas of higher return," Mr. Carney said.
That is exactly what has happened in Canada, with the loonie rising above US$1. Inflation in Canada has remained remarkably tame throughout the commodity boom.
Declining to let a currency rise, however can create a vicious circle, which can have far-reaching implications. "When large economies with undervalued exchange rates keep their currencies from appreciating, others feel pressured to follow," the governor said.
"Over time, macro policy becomes contorted: exchange rates more inflexible, monetary policy more hesitant, and economic controls more prevalent. The collective impact of this behaviour risks inflation and asset bubbles in emerging economies and, over time, subpar global growth."
As Canada's rising currency has helped restrain inflation, the Bank of Canada has taken a pause in raising interest rates. Many analysts expect the central bank to begin raising Canadian interest rates in the second half of the year, though they will be watching closely for any change in sentiment in the weeks ahead.
Mr. Porter at BMO said he would be watching for any change of tone at the bank's upcoming monetary policy report on April 13.
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