OTTAWA - The Bank of Canada took the wind out of the loonie's sails Tuesday, driving down the currency nearly two cents against the U.S. dollar with a warning that it was prepared to stick to low interest rates for some time.
And although the central bank's words have had short-term impacts on the currency before, this time the effect may last longer, economists said.
In one of the gloomier reports in months, the central bank's governing council declared that a strong loonie threatens Canada's economic recovery, saying its recent rise more than offset all the encouraging indicators seen over the summer.
"(The) heightened volatility and persistent strength in the Canadian dollar are working to slow growth and subdue inflation pressures," the bank said. "The current strength in the dollar is expected, over time, to more than fully offset the favourable developments since July."
As expected, the central bank kept its policy interest rate moored at the historic low of 0.25 per cent, the level it's been at since the spring.
The affect of the bank's statement could be seen immediately. The currency fell a penny against the U.S. dollar within minutes of the announcement and kept going, at one time trading down 2.17 cents U.S.
It closed on slightly better footing, though still down 1.98 cents at 95.17 cents U.S.
Economists said the reason for the big drop was not so much what the bank said about the dollar - it had made similar warnings for months - but more because markets had expected it would soon follow the lead of Australia, which has begun to raise interest rates.
Canada's central bank put a stop to that speculation Tuesday when it downgraded economic growth prospects for this year and 2011.
The bank now estimates the Canadian economy will shrink by 2.4 per cent in 2009, not 2.3 per cent as it predicted last month. Next year's forecast was unchanged at three per cent growth, but the bank downgraded its forecast for 2011 growth by two-tenths of a point to 3.3 per cent.
As significantly, it set back a full quarter its expectation for when economic output and inflation can be expected to return to where it wants them, to the fall of 2011.
"This is a somewhat more modest recovery in Canada than the average of previous economic cycles," the bank said.
With inflation nowhere in the horizon, there appears little urgency for governor Mark Carney to back off his conditional commitment to keep the central bank's policy rate at the lower bound of 0.25 per cent until next July. The thinking may be that short-term interest rates will stay at the historic floor even longer, perhaps until the end of next year.
"The delay in returning back to its target rate on inflation would allow a longer period of keeping rates on hold," said CIBC chief economist Avery Shenfeld.
"Financial markets tend to get edgy sitting still, but Carney is a man in no hurry to act."
Royal Bank currency strategist Matthew Strauss said Carney's gambit will have long-lasting impacts on the dollar.
That doesn't mean the dollar won't rise again, since the main driver will be oil prices and other external forces. But, he said, the bank governor has taken some of the speculation out of the calculation and going forward expects the loonie will underperform compared with other commodity-weighted currencies, such as the Australian dollar.
"It will definitely have an effect," he said. "Now the market knows exactly where the Bank of Canada and the Government of Canada stands."
Scotiabank economists Derek Holt and Karen Cordes said the markets should have seen it coming.
They wrote in a note to clients that it's ill-advised to lump Canada in with Australia, saying there are "night-and-day differences in the Canadian economy's export exposures and currency sensitivities."
Canada fell into a recession similar to one it experienced in the early 1990s, with its recovery prospects closely tied to the weak U.S. economy. Australia, which is benefiting from returning strong growth in China, never fell into even a technical recession.
Carney believes the Canadian dollar will keep future growth even more sluggish than it thought a few months ago.
Two indicators from Statistics Canada on Tuesday filled in the picture of an economy that is recovery, but not robustly.
The leading index of economic indicators rose 1.1 per cent in September, slightly less than the revised 1.2 per cent gain registered in August. And Canadian wholesalers took a hit in August as sales dropped 1.4 per cent.
The TD Bank said it now believes the Canadian economy likely contracted 0.2 per cent in August after a flat reading in July.
In September, the last time the bank pronounced on interest rates, Carney and the governing council had enthused that the recovery was going so well it was expecting to revise its July growth forecast that predicted 1.3 per-cent growth in the gross domestic product in the third quarter and three per cent in the fourth.
But that was when the bank expected the loonie to average 87 cents US through 2010.