Forex Investment and Currency Trading

The Bank of Canada endorsed market expectations this week in delivering a 50bp rate reduction for the second consecutive meeting. However, at the same time, the BoC was careful to rein in expectations that the aggressive moves would become the norm going forward. This represents a somewhat delicate
balancing act, but one that seems to come through in their statement. There were at least two ways in which the central bank chose to signal the shift towards more of a “datawatching” stance: first, they noted that core and headline inflation were currently running near 1½%, but that the “underlying trend” was judged to be about 2%; and, second, they characterized the risks around their inflation projections as balanced (though the base-case forecast has inflation returning to 2% only in 2010). While an easing bias remains
in place (“some further monetary stimulus will likely be required”), any additional moves will be made in the context of the 150bp already delivered and be dependent on global and domestic demand conditions.

…but looks to scale back its generosity in future
Amongst the group of major central banks that have kicked off an easing cycle, the BoC arguably faces a more robust domestic economy, a more stable housing sector and a “less challenged” money market than others. To be sure, funding pressures have increased again in recent weeks, but the spreads currently in place are significantly more subdued than in the U.S. and the U.K. As we have argued for sometime now, the one clear luxury that BoC officials enjoy that their colleagues abroad do not is a benign inflation performance. However, as the statement this week illustrates, some of the good inflation news is transitory (tied to once-andfor- all price adjustments and the 1 per cent reduction in the GST in January) and this provided the Bank the wherewithal to deliver some added “insurance” in terms of the growth outlook. Going forward, the inflation numbers are not expected to deteriorate rapidly, but the transitory influences
will begin to wane and this should cause the Bank of Canada to be a little more circumspect in its easing (market looks for one more 25bp rate reduction). The lags from exchange rate movements to inflation are commonly described as “long and variable”; however, the Canadian dollar has been broadly stable around parity over the past five months and most of the sharp disinflationary pressures on goods prices excluding
energy from the past appreciation should fade at a time when service price inflation (fuelled by still-strong wage growth) continues to run near 3½% on a year-ago basis

The central bank looking for slack to cap inflation
Indeed, what the BoC is banking on over the remainder of this year and next is that expected, below-potential growth will provide the necessary cap on price pressures that a strong Canadian dollar has until this point. The BoC revised down their full-year growth forecast for 2008 to 1.4% from a forecast of 1.8% in January and, for 2009, to 2.4% from 2.8%. Currently, the economy is believed to be operating “just above its production capacity”. If the hand-off from exchange rate influences to output gap pressures happens in a fortuitous manner, then – as suggested by the BoC – inflation should continue to hold comfortably below their 2% target rate over the medium-term, even with the 150bp of rate reductions seen
in the current easing cycle. However, the output gap has – in the past – not always shown a tight correlation with annual core inflation rates, with the correlation between the two measures sitting near 0.24 since 1985