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This past week, we saw the Bank of Canada release their interest rate decision. Many had speculated that the central bankers from the Great White North would follow the lead of their friends over at the Land Down Under and talk about a possible rate hike. However, they decided to play the villain – at least for the risk hungry – and kept interest rates unchanged at 0.25%.

Recent reports indicate that it will now take an additional three months for inflation to hit the BOC’s goal of 2%. BOC head Mark Carney and his posse said that they are committed to keeping rates at current levels until the inflation target is hit. The decision came as somewhat as a surprise. Recent signs had been pointing at better conditions in the Canadian economy…

The most notable of these was the improvement in the labor market. A report showed that joblessness in the country eased to 8.4% from 8.7% in August. Furthermore, a whopping 30,600 people were newly employed for the same month – more than six times the projected number!

More evidence of life could be seen in Canada’s recovering trade industry. The country’s most recent trade balance revealed that imports climbed by 8.3% in July, the first rise in five months. According to the data, the surge in imports was led by increased purchases of car parts and energy products. To some economists, the jump in imports suggest that that domestic demand was about to “turn the corner.” However, this was not exactly the case… at least for meantime.

On a broader time frame, it appears that things are still looking bleak. Amid the recession, Canada’s imports from the US have sunk by 20% since July 2008. During the same period, Canada’s exports have fallen by a faster pace of 35% which caused its trade deficit to widen. Just this August, Canada’s total exports dropped 5.1% to C$29.2 billion from a month earlier, causing its trade gap to expand further to C$1.99 billion. In fact, exports of machinery and equipments to the US alone are down by whopping 10.4% on a monthly basis.

Weak domestic demand is also making matters worse for Canada. Recent data shows that Canada’s manufacturing sales in August has unexpectedly slid by 2.1% after gaining by 5.2% the previous reporting period. Wholesale sales between July and August also fell by 1.4%. The headline and core retail sales also dipped in July by 0.6% and 0.8%, respectively.

The above factors all lead to a dismal inflation figure for Canada. The weak manufacturing, wholesale, and retail sales figures indicate that demand is not enough to push inflation, which measures the increase in the general prices of goods and services, upwards. In fact, Canadian CPI fell by an annualized 0.9% in September, which is way below the BOC’s 2% inflation target. The current drop in general prices is Canada’s largest percentage slide in more than five decades!

Furthermore, the persistent strength of the CAD is becoming more and more of a concern for the BOC. Lately, the CAD has been hitting fresh yearly highs against the USD day after day. Taken together, the CAD has gained 26% from its lows against the USD this year – pretty awesome, yeah? The rate at which the CAD is appreciating prevents the Canadian economy from reaching the BOC’s inflation target, forcing the central bank to keep rates at their low levels.

You see, a stronger domestic currency makes foreign goods relatively cheaper than local ones. So aside from weak demand, local manufacturers also feel pressured to keep their prices low in order to beat (or at least keep up with) the demand for foreign products. Thus, domestic prices stay at their current levels or even fall, which keeps inflation far from the BOC’s target.

Now, if you recall a little something called the Law of Supply and Demand from your basic economics classes, you might argue that price levels could be pushed higher by an increase in demand. But the problem with the Canadian economy is that, as I mentioned previously, consumer spending isn’t strong enough to warrant an increase in prices. This has the BOC crossing their fingers in hopes that their stimulus policies would overpower the effects of a stronger currency and eventually boost demand.

In the meantime, the BOC remains careful not to prod the CAD higher. The dance to recovery is a complex thing, and this was probably why Carney explicitly said that a rate hike is still far off despite the recent improvements in their economy. That day, we saw the USDCAD jump by more than 200 pips, effectively halting the CAD’s rally. Perhaps “trailing behind” the pack may work to Canada’s advantage someday…