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Inflation On Target; Exchange Rate Off Target

May 18, 2012

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Today, Statistics Canada reported an annual inflation rate of 2%, precisely in line with the Bank of Canada’s target. With inflation under control and renewed risks to the global economy, there is little rationale for the central bank to raise interest rates anytime soon.

In fact, the Bank of Canada should now be more concerned about the exchange rate than the inflation rate. Recent debate about Dutch disease highlights the Canadian dollar’s overvaluation.

While the loonie trades for about 98 U.S. cents on financial markets, the OECD calculates that its real purchasing power is equivalent to only 76 U.S. cents. This discrepancy hurts manufacturing and other industries that export output abroad, but buy inputs in Canada.

An interest-rate hike would aggravate this problem by driving up the exchange rate. On the contrary, the Bank of Canada should help alleviate Dutch disease by intervening in foreign-exchange markets to moderate the loonie to more competitive levels. (Directly managing their exchange rate is, in fact, how the Dutch cured Dutch disease.)

Wages vs. Inflation

The national average hourly wage rose by 2.3%, slightly more than inflation. However, Ontario’s provincial inflation rate of 2.1% is triple the average Ontario wage increase of 0.7%.

Erin Weir is an economist with the United Steelworkers union and a CCPA research associate.

UPDATE (May 19): Quoted in The Hamilton Spectator and St. John’s Telegram

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