Currency and Inflation Risk: Do You Have Answers For Concerned Clients?

By Evelyn Jacks

What's happening with the value of the Canadian dollar? Should investments be pulled out of US currencies? Concerned investors may have these and other questions on their minds as they attempt to make decisions on buying property and investments south of the border and hedging on currency values.

The Governor of the Bank of Canada, Mark Carney, has attempted to address some of these issues in a presentation October 28^th to the Standing Senate Committee on Banking, Trade and Commerce. He brought a cautious acknowledgement of improvement including the view that a global recovery from the financial crisis is beginning. However, Mr. Carney noted also that ìsignificant frailties remain.î

One of these significant frailties is the strength of the Canadian dollar, which is working against economic recovery in Canada, causing a drop in net exports. The bank now projects that the Canadian economy will contract by 2.4 per cent this year and then grow by 3.0 per cent in 2010 and 3.3 per cent in 2011.

Another is predictions around inflation. The Bank expects both core and total inflation to return to the 2 per cent target in the third quarter of 2011, in the meantime rising from a negative position to 1 per cent this quarter.

These issues point to volatility in currency valuations. Specifically, the Governor stated:

• The main upside risks to inflation relate to the possibility of a stronger-than-anticipated recovery in the global economy and more robust Canadian domestic demand.
• On the downside, the global recovery could be even more protracted than projected. (Editor's Note: . . .particularly in light of the H1N1 pandemic?)
• In addition, a stronger-than-assumed Canadian dollar, driven by global portfolio movements out of U.S.-dollar assets, could act as a significant further drag on growth and put additional downward pressure on inflation.

ìWhat ultimately matters,î says Mr. Carney, ìis the exchange rate's impact in conjunction with all other domestic and foreign factors on aggregate demand and inflation in Canada. To put it simply, the Bank looks at everything through the prism of achieving our inflation target.î

And that target is the reason why the Bank reaffirmed its conditional commitment to maintain its target for the overnight rate at 1/4 per cent until the end of June 2010 with a view to achieving a 2% inflation target.