A Canadian dollar, or loonie, sits on top of its American counterpart.
Trading currencies is a head-scratcher at the best of times and today's release of the Canadian inflation data is likely to make it more so.
Here's why. Inflation is widely expected to have cooled off in February to a modest level given the slack in the economy, yet strategists and currency traders expect the Bank of Canada, in inflation-fighting mode, will begin raising interest rates this summer. And it will start long before the U.S. Federal Reserve Board begins its own rate-hiking regimen.
The speculation over rising interest rates in Canada is behind much of the recent surge in the Canadian dollar as it approaches parity with the U.S. dollar, but one consequence of a rising loonie is that it also serves to reduce inflation pressures and make imports such as food and other goods cheaper.
What are the expectations? The core consumer price index, which excludes the eight most volatile items, is forecast to have declined to 1.7 per cent in February, compared with 2 per cent in January. That remains well below the Bank of Canada's target rate of 2 per cent.
The overall rate of inflation is forecast at 1.4 per cent, compared with 1.9 per cent in January.
And economists generally expect inflation will remain tepid.
"Theory and reality are diverging from each other," said Eric Lascelles, chief economics and rates strategist with TD Securities Inc. Based on the textbooks there would seem to be no need for the central bank to begin raising rates with inflation rates at such modest levels. "But inflation shouldn't be moderate at this point in the cycle," he said. "It should be quite soft."
High and rising house and car prices, a healthier-than-anticipated economy and unsustainable borrowing by consumers suggest the central bank should take some steps to cool things down, economists say.
Rate hikes are coming "I think the consumer price index will be fairly tame," said John Clinkard, chief economist for Canada with Deutsche Bank AG. "There were a number of one-time factors in January not present in February."
Nevertheless, Mr. Clinkard expects the Bank of Canada will raise its target overnight rate by 50 basis points in July to three-quarters of one per cent. (A basis point is 1/100th of a percentage point.)
"I don't think [cooling inflation]will change the bank's strategy at this point because there are so many indications early in the first quarter that growth is strong," Mr. Clinkard said.
However, one of the risks of a rise in interest rates is an even stronger Canadian dollar which makes it tougher for exporters.
"The [strong loonie]had been a concern of the bank, but my sense is it is not as important as it has been," Mr. Clinkard said. "Reality has caught up to expectations." He does not expect the dollar to move significantly over par. Yesterday, the loonie fell almost a third of a percentage point to 98.7 cents (U.S.).
"The recent ramp-up in the dollar will act as a bit of a dampener on inflation during the next couple of months," said Douglas Porter, deputy chief economist with BMO Nesbitt Burns. "The surprise is that after such a deep recession, inflation is not even lower."
The rise in the loonie indicates that traders in the currency markets are anticipating the central bank will begin lifting rates in July from their emergency low levels, he said. BMO Nesbitt Burns expects four consecutive rate hikes of 25 basis points by the end of the year, bringing the target overnight bank rate to 1.25 per cent.
"It will be stimulative [to the economy] just not as stimulative," Mr. Porter said. "I think the Bank of Canada will be reluctant to raise rates as much if the Fed is still on hold." The Bank of Canada has held rates steady since April 21, 2009.
While economic models would suggest that interest rate hikes are not warranted given current inflation levels, the fact that rates are at emergency low levels following the credit crisis supports the need to raise rates, said TD Securities' Mr. Lascelles. "That's the attitude we are bringing to it."
The Bank of Canada can raise rates 100 basis points before the Fed starts without a problem, Mr. Lascelles said. During the past decade the gap between the Bank of Canada rate and the federal funds rate has been that wide one-quarter of the time, he said. "The Bank of Canada can afford to stretch the elastic against the Fed."
He does not expect the Fed to begin raising rates until early next year, although it will be unwinding its quantitative easing programs before then.