Commodity prices aren’t the best predictor of the Canadian dollar’s future exchange rate, according to a new study from the C.D. Howe Institute.
In “Understanding the volatility of the Canadian exchange rate,” authors Martin Eichenbaum, Benjamin K. Johannsen and Sergio Rebelo find the current real exchange rate is more useful than commodity prices for forecasting changes in the Canada/U.S. nominal exchange rate.
The report looks at the historical determinants of the Canadian/U.S. dollar nominal exchange rate and whether they can be used to accurately forecast long-run future rates. (The nominal exchange rate is how many U.S. dollars can be exchanged for a loonie, while the real exchange rate is the relative cost of a typical bundle of consumer goods in Canada compared to the U.S.)
Canada’s real exchange rate with the United States is mean-reverting, the report says: when the real exchange rate is high, it tends to fall to its long-run average. This is because the shocks driving the rate (movement in commodity prices, changes in government spending and temporary shocks to the U.S. economy) aren’t permanent, the authors say.
They also find the current real exchange rate “displays a tight negative correlation with future values of the Canadian dollar relative to the U.S. dollar.” That’s because Canadian and U.S. monetary policies are similar in that both countries use a short-term interest rate to control inflation and don’t explicitly manage the exchange rate. As a result, there haven’t been persistent changes in the relative price levels of the two countries.
“A fundamental question is whether Canadian policymakers are satisfied with the current inflation targeting regime,” the report says.
A potential cost of this regime is that Canada’s real exchange rate is highly volatile, the report says, while a benefit is that consumers and firms can mostly avoid potentially costly changes in nominal prices and wages that would be required if the nominal exchange rate did not adjust in a flexible manner.
The authors aim to compare these tradeoffs for policymakers, which they say “should play an important role in the process leading to the Bank of Canada’s next five-year agreement with the government.”
Read the full report here.