OTTAWA -- The Canadian dollar fell more than one cent Tuesday morning after the Bank of Canada warned the currency is undermining Canada's recovery so much it has more than offset favourable developments since July.
As expected, the bank kept its policy interest rate at the historic low of 0.25 per cent, the level it's been at since the spring.
But it was the bank's comments on the loonie and economic growth going forward that had markets buzzing.
The dollar fell immediately following the 9 a.m. EST release, dropping more than a cent to fall below 96 cents US after closing at 97.15 cents US Monday.
"The markets shouldn't have been surprised in this manner," said Scotiabank economists Derek Holt and Karen Cordes in a note to clients.
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Analysts have attributed the recent sharp run-up in the Canadian dollar to market expectations that the Bank of Canada would follow Australia's recent surprise move to begin raising interest rates.
But the Canadian central bank threw cold water on that notion Tuesday in a gloomy statement that suggested, if anything, it might keep the policy rate at the so-called lower bound past the "conditional commitment," which ends next July.
The Scotiabank economists wrote that it's ill-advised to lump Canada in with Australia, saying there are "night-and-day differences in the Canadian economy's export exposures and currency sensitivities."
The Bank of Canada's statement today says 'a recovery in economic activity is underway in Canada and listed a string of developments that have gone right since the recession, which likely ended in June.
"However, heightened volatility and persistent strength in the Canadian dollar are working to slow growth and subdue inflation pressures," it added. "The current strength in the dollar is expected, over time, to more than fully offset the favourable developments since July."
The central bank said it is also keeping open its emergency liquidity instruments to ensure credit markets continue to function.
The Bank of Canada has made an unusual commitment to keep its key rates unchanged until the middle of next year but economists have speculated that might change if the economy grew too quickly and inflation threatened to get out of hand.
Markets, seeing improved conditions and the bank's recent positive statements about the recovery, were even more convinced the bank would move as early as this winter or spring.
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In September, the last time the bank pronounced on interest rates, governor Mark Carney and the governing council had enthused that the recovery was going so well it was expecting to revise its July growth forecast that predicted 1.3 per-cent growth in the gross domestic product in the third quarter and three per cent in the fourth.
But that was when the bank expected the loonie to average 87 cents US through 2010.
It hasn't been behaving as the bank thought. The loonie is now about 10 cents US above the value used in the bank's projection, making Canadian-produced goods less competitive in the U.S. market.
On Monday, the loonie gained 0.83 cents, partly on speculation Carney would hint at exit strategies from its extremely stimulating stance. The bank now says the recovery will be slower and the economy will take longer to return to normal.
The bank now estimates the economy will shrink slightly more than it had expected in July -- not less as it said last month -- declining by one-tenth of a point to 2.4 per cent. And growth, while the same in 2010 at three per cent, will be more muted in 2011 by two-tenths of a point to 3.3 per cent.
"This is a somewhat more modest recovery in Canada than the average of previous economic cycles," the bank said.
As well, it said it now expects the economy's output gap -- the difference between actual and capacity to produce -- won't be closed until the third quarter of 2011, a quarter later than previously predicted. Inflation also won't return to target of two per cent until a quarter later, two full years from now.
Although the bank does not make a direct threat to intervene in the currency markets, Tuesday's more gloomy tone was likely intended to dampen speculation on the currency. The short-term market response is likely exactly what the bank wanted.
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The strong dollar is not only dousing inflation, it is also undermining economic activity in the export sector, particularly Ontario's manufacturing base.
A strong currency erodes Canada's ability to export what it makes by making Canadian products less competitive in foreign markets.
