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### Viewing cable 07OTTAWA1991, THE CANADIAN DOLLAR AND INFLATION CONTROL

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Reference ID | Created | Released | Classification | Origin
--- | --- | --- | --- | ---
07OTTAWA1991 | 2007-10-29 20:06 | 2011-04-28 00:00 | UNCLASSIFIED//FOR OFFICIAL USE ONLY | Embassy Ottawa

`

    VZCZCXRO2845
    RR RUEHVC RUEHQU
    DE RUEHOT #1991/01 3022006
    ZNR UUUUU ZZH
    R 292006Z OCT 07 ZDK CTG UR SVC
    FM AMEMBASSY OTTAWA
    TO RUEHC/SECSTATE WASHDC 6800
    INFO RUCPDOC/USDOC WASHDC
    RUEATRS/DEPT OF TREASURY WASHDC
    RUCNCAN/ALL CANADIAN POSTS COLLECTIVE

` `

    UNCLAS SECTION 01 OF 03 OTTAWA 001991

    SIPDIS

    SENSITIVE

    SIPDIS

    DEPT FOR WHA/CAN, EEB/IFD/OMA AND INR

    USDOC FOR 4310/MAC/ONA

    TREASURY FOR IMI (FAIBISHENKO)

    TREASURY PASS FEDERAL RESERVE

    E.O. 12958: N/A
    TAGS: ECON EFIN CA
    SUBJECT:  THE CANADIAN DOLLAR AND INFLATION CONTROL

    REF:  (A) OTTAWA 1869 (NEW CENTRAL BANK GOVERNOR)

      (B) OTTAWA 1600 (CLIMBING CANADIAN DOLLAR)
      (C) OTTAWA 0921 (HARPER GOV'T AND CANADIAN BUSINESS)

    SUMMARY/INTRODUCTION
    --------------------

    SENSITIVE, BUT UNCLASSIFIED.  NOT FOR DISTRIBUTION OUTSIDE USG
    CHANNELS.

    ¶1. (u) Summary:  The consequences of the rapid appreciation of the
    Canadian dollar's (the "loonie") value to above $1 U.S. for the
    first time in more than three decades are a topic of daily public
    discussion in Canada.  Bank of Canada Governor David Dodge and other
    Bank officials have hinted that there is a speculative component in
    the latest round of appreciation; Finance Minister Jim Flaherty has
    called on retailers to ensure that the currency's strength fully
    passes through into lower consumer prices; and economic analysts
    have raised concerns that the stronger "loonie" is causing
    structural job losses in the manufacturing sector and reduced export
    revenues.

    ¶2. (sbu) Although the Canadian economy is operating above its
    expected production potential, we see no sign that the Bank of
    Canada will relent from its 16-year-old prime mission of inflation
    control.  While recent Bank messages appear less focused on
    inflation than in the past, recent events -- the U.S. economic
    slowdown, the worldwide tightening of credit markets, and the strong
    "loonie" - have reduced the Bank's inflation risk assessment.  The
    Bank now expects inflation to moderate to two percent during 2008
    without further interest rate increases.  With respect to the
    exchange rate, the Bank's standing commitment is to ensure that
    market movements are "orderly."  END SUMMARY

    THE CENTRAL BANK'S PRIME DIRECTIVE:  INFLATION CONTROL
    --------------------------------------------- ---------

    ¶3. (u) During the late 1980s and early 1990s, Canada struggled with
    a complex of economic problems including high public sector
    deficits, unemployment, and inflation.  In February 1991, the GOC
    and the Bank of Canada jointly agreed on a series of targets for
    controlling consumer price inflation over a five-year period, and
    inflation control became the Bank's mandate.

    ¶4. (u) This policy shift was intensely controversial.  Economists
    debated the optimal rate of inflation, including the possibility of
    price stability (zero inflation).  Politicians and the general
    public debated whether any effort to control inflation would be
    worth the pain involved, or whether economic authorities, including
    the central bank, should be focused on employment.

    ¶5. (u) Then-Bank of Canada Governor John Crow - who had advocated
    inflation targeting - was demonized by the Canadian public and
    media, and probably as a result, he was not considered by the
    government in 1993 for appointment to a second seven-year term.
    Nevertheless, the government's inflation targeting agreement with
    the Bank was a lasting success.  Over the last 15 years, inflation
    has been contained within a target band of one to three percent, and
    the agreement has been extended a number of times, most recently in
    November 2006 for a further five-year period.

    THE CLIMBING CANADIAN DOLLAR
    ----------------------------

    ¶6. (u) Ref (B) outlines the effects of the steep appreciation of the
    Canadian dollar since 1993 (by about 60 percent against the U.S.
    currency).  The rise has been driven in large measure by rising
    prices for exported commodities, particularly oil, but also metals
    and wheat.  While many analysts expected such a dramatic change
    Qand wheat.  While many analysts expected such a dramatic change
    would cause economy-wide problems in this open trading nation,
    Canada's macroeconomic performance has been smooth and strong.

    ¶7. (u) Although the "loonie's" appreciation has accelerated job
    losses in Canada's manufacturing sector, notably in forestry and
    textiles/clothing, a stronger Canadian dollar has not harmed overall
    job creation.  In September of this year, the official unemployment
    rate dropped below 6 percent, its lowest level in 35 years, largely
    due to growth in the resource industries and construction.  The
    Canadian dollar's appreciation has also moderated the country's
    commodity boom somewhat (as commodities are priced in U.S. dollars),

    OTTAWA 00001991  002 OF 003

    easing the central bank's job in meeting its inflation targets.
    Finally, the new affordability of imported machinery is helping
    companies reinvest in ways that should enhance productivity, a
    longstanding worry of Canada's economic policymakers.

    POLITICAL REACTION
    ------------------

    ¶8. (u) Although the economy is performing well, the Canadian
    dollar's rise has prompted concern in Canada's business and economic
    establishment.  Prior to the latest round of appreciation -- which
    took the exchange rate from around US 93 cents in mid-August to
    US$1.04 in late October -- several business leaders called for
    official intervention to contain the dollar's rise and protect
    Canada's export competitiveness.  Consumer groups have complained
    about Canadian retail prices, notably for vehicles, which have
    remained significantly above their US equivalents.

    ¶9. (sbu) On October 23, Finance Minister Jim Flaherty, who has an
    affinity for populist causes (ref C), publicly urged industry to
    reduce domestic consumer prices to reflect the increased purchasing
    power of the dollar.  Flaherty may have a mix of political and
    economic motives:  as a politician he wants to deflect consumer
    anger away from the government and toward retailers, while as
    Finance Minister he wants to contain the loss of tax revenue due to
    consumers crossing the border to shop in the United States.
    Flaherty has also preached the virtues of productivity-enhancing
    investment to manufacturers.

    ¶10. (u) Bank of Canada Governor David Dodge remarked on October 21
    that the latest round of appreciation has been "abnormally quick and
    doesn't seem to be related to the domestic factors which would
    normally lead to that sort of appreciation."  Professional opinion
    among Canadian economists is that fundamentals justify an exchange
    rate somewhere between US 90 cents and US$1.00, and that recent
    appreciation may have been driven disproportionately by the climbing
    price of oil.  In its latest Monetary Policy Report (released
    October 16), the Bank of Canada assumes that the Canadian dollar
    should average U.S. 98 cents over the next year.  A senior Bank
    official told EMIN last week that he believes that about U.S. 5
    cents of the Canadian dollar's valuation probably represents
    currency speculation.  (At this year's prices, oil and oil products
    make up around ten percent of Canada's exports).

    MONETARY POLICY MESSAGE STAYS THE COURSE
    ----------------------------------------

    ¶11. (sbu) The flood of recent commentary on the exchange rate -
    coming on top of signs of a U.S. economic slowdown and the
    tightening of credit markets since August - might have been taken to
    suggest that Canada's monetary authorities could be ready to change
    the strict inflation targeting that has guided them since 1991.
    However, messages from the Bank of Canada so far lend no support to
    this idea.

    ¶12. (u) While the central bank's concern about inflation may have
    moderated over the past two quarters, this is more likely because
    inflation appears under control than due to any change in the Bank's
    vigilance.  The October Monetary Policy Report devotes little
    discussion to the Canadian dollar other than as a positive factor in
    inflation control.  The report makes the following key points:

    -- Early information for the third quarter suggested that the strong
    Canadian dollar was leading to a marked reduction in net exports.

    -- The credit market tightening since August has added about 25
    Q-- The credit market tightening since August has added about 25
    basis points to the cost of credit for businesses and households.

    -- The slowdown in the U.S. housing sector has been sharper than
    expected, moderating demand in Canada.

    -- Even with all these factors, Canada's economy is now operating
    about 3/4 of a percent above its production potential, which is
    above expectations, and consumer price inflation has been somewhat
    above the 2 percent annual target.

    -- High commodity prices are pushing sustained economic growth,
    corporate profits, and tax revenues.  With no change in Canadian
    interest rates, the Canadian economy would remain in excess demand
    through to early 2009.

    OTTAWA 00001991  003 OF 003

    -- However, the core rate of inflation is expected to ease to around
    2 percent in the second half of 2008 and stay at that level through
    ¶2009.  The stronger Canadian dollar contributes to keeping inflation
    under control and has shortened the time frame during which the Bank
    expects inflation to subside toward the 2 percent target.

    COMMENT
    -------

    ¶13. (sbu) While Canadian policymakers are commenting more often on
    currency issues and their impact on economic structure, this
    reflects popular discussion and media questions since the Canadian
    dollar reached -- and exceeded -- parity with its U.S. counterpart.
    Our reading of more formal messaging from the Bank of Canada and the
    Department of Finance reveals no sign of change in Canada's
    commitment to control inflation.

    WILKINS

`