VZCZCXRO2845
RR RUEHVC RUEHQU
DE RUEHOT #1991/01 3022006
ZNR UUUUU ZZH
R 292006Z OCT 07 ZDK CTG UR SVC
FM AMEMBASSY OTTAWA
TO RUEHC/SECSTATE WASHDC 6800
INFO RUCPDOC/USDOC WASHDC
RUEATRS/DEPT OF TREASURY WASHDC
RUCNCAN/ALL CANADIAN POSTS COLLECTIVE

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