The Bank of Canada - One Small Step for the Dollar, One Giant Leap for Gold?

By: Paul Kasriel | Wed, Dec 5, 2007
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Today the Bank of Canada (BOC) surprised the markets with a 25 basis point cut in its policy interest rate to 4.25%. This is the first decline in the BOC's policy rate since April 2004. The BOC cited downside risks to its inflation forecast as a justification for today's policy rate cut. The BOC strategically is attempting to keep the Canadian all-items CPI inflation rate around 2%. But for tactical policy decisions, the BOC relies more on a "core" measure of CPI inflation. As Chart 1 shows, Canadian "core" inflation has been in a downward trend in the second half of 2007, slowing to 1.8% in October on a year-over-year basis in October. In contrast, Canadian all-items inflation has been in a rising trend, up 2.4% year-over-year in October.

Chart 1

In one breath, the BOC cited downside risks to inflation as justification for today's policy rate cut. In another breath, the BOC stated: "Overall, the Canadian economy continues to operate above its production capacity. Given the strength of domestic demand and weak productivity growth, there continue to be upside risks to the Bank's inflation projection." [emphasis added]. So, which is it? Downside or upside risks to Canadian inflation?

Basically, the BOC sees downside risks to Canadian economic growth from tightened credit conditions north of THE border and tightened credit conditions in the Lower 48. Canada still depends mightily on exports to the U.S. for the sale of its production. With U.S. domestic demand growth softening and with the Canadian dollar having reached parity with its U.S. counterpart, the BOC is frightened that a potential U.S. recession could drag the Canadian economy under, too.

As this is being written (noon CST), the greenback has rallied 1.35% against the loonie. Whether the Bank of England (BOE) on Thursday follows the lead of one of its Dominion members on Thursday still is an open question. But the odds are that the BOE will begin a series of policy interest rate cuts soon in an attempt to forestall the onset of a UK recession. And after the BOE cuts, the European Central Bank will likely cut its policy rate. The Bank of Japan won't cut. It just won't raise its policy rate as it had intended to several months ago. These actions by developed-world central banks might cushion the foreign exchange value of the U.S. dollar.

As Chart 2 illustrates further, central banks in the developed world are cutting their policy interests as their all-items inflation rates go vertical. So, while fiat currencies float along in tandem as their supplies increase in tandem, all of them are likely to sink in value relative to the genuine "reserve currency" - gold. As this is commentary is being wrapped up (1:55 pm CST), the nearby gold futures contract in terms of U.S. dollars is up in price 1.90%. As developed-world central banks attempt to figuratively and literally "paper-over" the credit market implosion by creating more central bank money, the price of gold in terms of these fiat currencies - not just the U.S .dollar -- is likely to keep on rising.

Chart 2



Paul Kasriel

Author: Paul Kasriel

Paul L. Kasriel
Director of Economic Research
The Northern Trust Company
Economic Research Department
Positive Economic Commentary
"The economics of what is, rather than what you might like it to be."
50 South LaSalle Street, Chicago, Illinois 60675

Paul Kasriel

Paul joined the economic research unit of The Northern Trust Company in 1986 as Vice President and Economist, being named Senior Vice President and Director of Economic Research in 2000. His economic and interest rate forecasts are used both internally and by clients. The accuracy of the Economic Research Department's forecasts has consistently been highly-ranked in the Blue Chip survey of about 50 forecasters over the years. To that point, Paul received the prestigious 2006 Lawrence R. Klein Award for having the most accurate economic forecast among the Blue Chip survey participants for the years 2002 through 2005. The accuracy of Paul's 2008 economic forecast was ranked in the top five of The Wall Street Journal survey panel of economists. In January 2009, The Wall Street Journal and Forbes cited Paul as one of the few who identified early on the formation of the housing bubble and foresaw the economic and financial market havoc that would ensue after the bubble inevitably burst. Through written commentaries containing his straightforward and often nonconsensus analysis of economic and financial market issues, Paul has developed a loyal following in the financial community. The Northern's economic website was listed as one of the top ten most interesting by The Wall Street Journal. Paul is the co-author of a book entitled Seven Indicators That Move Markets.

Paul began his career as a research economist at the Federal Reserve Bank of Chicago. He has taught courses in finance at the DePaul University Kellstadt Graduate School of Business and at the Northwestern University Kellogg Graduate School of Management. Paul serves on the Economic Advisory Committee of the American Bankers Association.

The opinions expressed herein are those of the author and do not necessarily represent the views of The Northern Trust Company. The information herein is based on sources which The Northern Trust Company believes to be reliable, but we cannot warrant its accuracy or completeness. Such information is subject to change and is not intended to influence your investment decisions.

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