THE CANADIAN DOLLAR AND INFLATION CONTROL

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