Loonie's disconnect from oil prices makes higher interest rates necessary: Tiff Macklem

The weak Canadian dollar is complicating the Bank of Canada's fight against inflation and could result in higher interest rates than would have been necessary if the currency had behaved as it has in the past.

The comments followed the central bank's surprise decision on July 13 to increase the benchmark interest rate a full percentage point after the Bank of Canada's latest quarterly outlook predicted headline inflation was on track to crest eight percent this summer.

Macklem said in an exclusive interview with the Financial Post that the central bank needs to do more through interest rates because the Canadian dollar hasn't appreciated as much. We are taking that into account.

The Canadian dollar has not traded more than 80 cents against the U.S. dollar this year. The value of the currency American importers need to purchase Canadian crude increases when the price of oil goes up.

It is a bad time for that link to break. The consumer price index increased in part due to higher costs for consumer goods. Some of the cost increases would have been mitigated by a stronger exchange rate.

When oil prices go up, the Canadian dollar acts as a stabilizer in the economy.

The Canadian dollar appreciates when the price of oil in the US goes up. What do you think about that? The governor said that the price in Canadian dollars doesn't go up as much because the Canadian dollar absorbs some of the inflation. It spreads the benefits of a higher oil price to Canada, because we are an oil exporting country. The economy is spread more across it.

The Bank of Canada raised its interest rate by a full percentage point, but the boost to the Canadian dollar didn't last. The Canadian dollar was roughly the same as it was earlier in the week.

Markets are focused on what is happening in the US. Following the release of data on July 13 that showed the U.S. consumer price index increased 9.1 per cent from June 2021, the U.S. dollar has been on a tear.

According to a note to his clients, the dollar is crushing every major currency. Evidence of a continued acceleration in prices, along with a broadening in core pressures have heightened expectations for a more aggressive response from the Federal Reserve in the near term.

The Fed is likely to follow the Bank of Canada in implementing a one-percentage-point increase in the federal funds rate. The Canadian dollar was not going to get a boost from the current interest-differential with the U.S..

There is an unusual situation in which funds are flowing into the United States for yield-seeking and safe-haven reasons.

The Bank of Canada didn't see the inflation surge coming because of a weaker link between the currency and oil prices. The models used by the central bank underestimated the effect of oil prices on inflation.

The link between oil prices and the Canadian dollar has broken down because of a shift in the outlook for Canadian oil exports and expectations for the U.S. monetary policy, according to Macklem.

When oil prices go up sharply, the investment in oil and gas is not as high as it has been in the past. You're not seeing a big investment boom, you're not seeing a big influx of foreign investment, and you're not seeing more demand for Canadian dollars.

We are not getting the historical investment boom in oil and gas that we've had when oil prices go up sharply

Tiff Macklem

As the Fed increases interest rates, the U.S. dollar is taking flight faster than the Canadian dollar. Macklem noted that the Canadian dollar has fallen behind its southern counterpart, making it seem like it is more of a loser.

Macklem said interest rates have gone up very quickly because of the U.S. Federal Reserve's monetary policy pivot. 75 percent of our trade goes to the U.S. dollar exchange rate, so that strengthens the U.S. dollar a lot.

The email address is shughes@postmedia.

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