Recent efforts by the Bank of Canada to “talk down” the dollar in its public statements have led to public perceptions that the Bank is considering action to weaken it.In permitting this response to gather momentum, the Bank has stepped onto a slippery slope, because if talk seems to be failing, people might reasonably expect direct intervention in the exchange market to follow.Bank of Canada, inflation rate, exchange rate

David Laidler

English

Research Papers in Economics

e-brief
Getting Talk Back on Target:  
The Exchange Rate and the Inflation Rate
By
David Laidler
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December 2, 2009
 Recent efforts by the Bank of Canada to “talk down” the dollar in its public
statements have led to public perceptions that the Bank is considering action to
weaken it.
 In permitting this response to gather momentum, the Bank has stepped onto a
slippery slope, because if talk seems to be failing, people might reasonably expect
direct intervention in the exchange market to follow.
1 The phrases in quotation marks are taken from p. 1 of the Bank’s October Monetary Policy Report.
Is the Canadian dollar too strong, and is the Bank of Canada considering action to weaken it? Although a careful
parsing of the Bank’s recent statements reveals a more nuanced message, too many people have extracted
simple answers from them: “yes” and “yes.” 
The Bank needs to take more care than it has recently about encouraging such expectations. Its
announcements, no less than its actions, should first and foremost stress the control of inflation. It is the job of
markets to find the exchange rate compatible with the timely restoration of CPI inflation to 2 percent. The
changes in international economic circumstances that have been driving the currency’s recent appreciation are
not things the Bank of Canada can control.
Governor Carney recently remarked that though markets sometimes lose their focus, the Bank of Canada
does not. While he meant that the Bank always keeps its goal of 2 percent inflation squarely in front of it – and
the Bank’s recent prepared texts have consistently connected its concerns about the exchange rate to the
medium-term prospects for inflation – the frequency and insistence of its public references to the dollar’s recent
appreciation and its likely effects on the pace of economic recovery in the next few months have distracted
attention from this more distant goal. 
What the public is hearing is that the Bank has been surprised by the dollar’s appreciation from the US87-
cent range that it “assumed” in its July Monetary Policy Report, and that the currency’s “heightened volatility
and persistent strength . . . are working to slow growth,” and that the dollar’s “current strength… is expected,
over time, to more than fully offset the favourable developments since July.”
1And for most of that public, the
Bank’s recent efforts to “talk the dollar down,” are welcome not because they might move CPI inflation back to
2 percent in mid-2011, rather than to the 1.9 percent rate that is currently forecast, but because they might
improve the competitiveness of Canadian exports in the US market right now.
In permitting this response to gather momentum, the Bank has stepped onto a slippery slope, because if talk
seems to be failing, people might reasonably expect direct intervention in the exchange market to follow.Already, one prominent bank economist has urged the Bank to consider intervening, a proposal that received prompt and
prominent editorial support.
2
But intervention has its pitfalls. It always requires the Bank of Canada to create enough new Canadian dollars to decisively
alter the balance of supply and demand for the currency. If it does this when their supply is already compatible with getting and
then keeping inflation on target in the face of other developments at home and abroad, it risks an inflation overshoot, which in
due course would force it to choose between reversing its exchange-rate policies to get inflation back on track, or letting that
target slip. This is how a policy regime ostensibly aimed at stable inflation can veer toward one aimed at the exchange rate, and
have its credibility among the public at large eroded too, as the incompatibility of these two goals is revealed. 
Granted, this does not have to happen. Talk can be helpful and intervention can be benign under some circumstances.
The Bank’s recent reminder about some of the differences between Canada and Australia was surely useful to those traders
who were buying the Canadian dollar because the Reserve Bank of Australia had raised its interest rate. More generally, a
central bank that knows more about domestic developments relevant to the exchange rate than do traders – a clear
possibility in the case of a smaller economy with a currency lightly used internationally – can make the occasional harmless
profit by trading on that knowledge.
But in Canada in recent weeks, it has been the dollar’s overall appreciation since the July Monetary Policy Report was
prepared that has attracted comments from the Bank and has prompted calls for it to abandon its decade-plus policy of
letting the exchange rate float completely freely. 
This appreciation has had nothing to do with badly informed traders, or with domestic events that have been
misunderstood or overlooked abroad. It has had much more to do with a broadly based depreciation of the US dollar. The
Canadian-US dollar exchange rate has indeed appreciated since May 2009, when the Bank began drafting its July Report, but
the C$-Euro exchange rate has seen no significant change over the same period (Figure 1).
INDEPENDENT REASONED RELEVANT
| 2 e-brief
2 See Avery Shenfield “Is No Policy the Right Policy?” CIBC Economic Insights, October 27th 2009, and “When to Intervene” The Globe and
Mail October 28th, 2009.
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4/15/2009 5/13/2009 6/11/2009 7/10/2009 8/10/20099 /8/2009 10/6/2009 11/4/2009
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Canadian Dollar vs US Dollar (Left Axis)
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Canadian Dollar vs Euro (Right Axis)
Figure 1 - The Canadian Dollar vis-à-vis the US Dollar and the Euro
Source: Bank of Canada.INDEPENDENT REASONED RELEVANT
e-brief /3
The Bank of Canada is well aware of the US dollar’s recent weakening, attributing it to “portfolio movements,” as though
these were divorced from economic fundamentals. But is this really the case? Last year, as we all know, a US consumption
boom, financed by something akin to an international Ponzi scheme with securitized mortgages at its heart, collapsed. Now, an
already weak US fiscal situation is deteriorating rapidly, and though there currently seems to be no political will to do anything
about it, any replacement of consumer by government spending must necessarily come to an end eventually. 
Restoration of demand for US output to a sustainable full-employment level will therefore require a substantial and, as far
as one can see, permanent increase in US net exports. Perhaps it is this economic fundamental, which requires a depreciation
of the US real exchange rate, that underlies the US dollar’s continuing weakness. 
The idea that the Bank of Canada can or should insulate the Canadian economy from such deep-seated changes, either by
talk or exchange-market intervention, is not just misguided but also dangerous. Our dollar’s appreciation is simply
announcing their onset. Canadians need to receive and act upon this message, and policymakers should provide an economic
environment that reduces their chances of error as they do so. Under current circumstances, therefore, the Bank of Canada’s
prime responsibility is to keep the transmission of information as clear as possible, not to garble it with talk about a variable
that, within the current monetary-policy framework, is beyond its control. 
If the Bank now believes that it has been underestimating the monetary stimulus needed to close the domestic output gap
and get inflation back to 2 percent in a timely fashion, it should say so and act accordingly. It has plenty of scope for further
expansionary measures – a further injection of liquidity into the clearing system, for example. But it should not confuse
Canadians with statements that could be read as suggesting that the exchange rate is becoming a policy goal in its own right.
The Bank can do nothing about the economic fundamentals affecting the Canadian dollar’s real long-term external value. The
more clearly it communicates this fact and refocuses public attention on the variables that it can affect, namely the output gap
and the domestic inflation rate, the better.INDEPENDENT REASONED RELEVANT
e-brief /4
This e-brief is a publication of the C.D. Howe Institute.
David Laidler is Fellow-in-Residence at the C.D. Howe Institute.
For more information call David Laidler at 416-865-1904.
This e-brief is available at www.cdhowe.org.
Permission is granted to reprint this text if the content is not altered and proper attribution is provided.
References
Bank of Canada. 2009. Monetary Policy Report. October.
Avery Shenfeld. 2009. “Is No Policy the Right Policy?” CIBC Economic Insights. October 27.

Getting Talk Back on Target: The Exchange Rate and the Inflation Rate

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