The dollar in the 1990s
While the Canadian dollar began the 1990s
on a strong note, it weakened against its U.S.
counterpart through much of the decade, declining
from a high of US$0.8934 on 4 November 1991
to close the decade at US$0.6929.
Through 1990 and most of 1991, the
Canadian dollar climbed against its U.S. counterpart
(and against major overseas currencies). This was
largely due to a further tightening of monetary
policy within the context of inflation-reduction
targets announced in February 1991, and widening
interest rate differentials that favoured Canadian
instruments.
After cresting in the autumn of 1991 at its
highest level against the U.S. dollar since the late
1970s, the Canadian dollar began to depreciate,
falling sharply through 1992 to close the year at
US$0.7868. The gradual, but sustained decline in
the value of the Canadian dollar, which continued
through 1993 and 1994, reflected various factors.
With inflation falling to—and for a time below—
the target range established in 1991 and with
significant unused capacity in the economy, the
Bank of Canada sought easier monetary conditions
through lower interest rates. Downward pressure on
the currency also reflected increasing concern
about persistent budgetary problems at both
the federal and provincial levels, softening
commodity prices, and large current account deficits.
92. The appreciation of the Canadian dollar following the signing of the FTA gave rise to a myth at that time that the Canadian government had secretly
agreed to engineer a higher value for the Canadian dollar as a quid pro quo for the free trade agreement with the United States.
The international environment was also unfavourable.
The Exchange Rate Mechanism in Europe came
under repeated attack through 1992 and 1993,
followed by rising U.S. interest rates through 1994.
The Mexican peso crisis of 1994 and early 1995
also drew investor attention to the weakness of
Canada’s fundamentals, especially its large fiscal and
current account deficits.
A degree of stability in the Canadian dollar
was temporarily re-established through 1995 and
1996 for a number of reasons. These included
higher short-term interest rates (at least early in the
period), evidence that fiscal problems were being
resolved,
a marked improvement in Canada’s
balance of payments, partly because of strengthening commodity prices, and a diminished focus on
constitutional issues. The Canadian dollar traded in
a relatively narrow range close to US$0.73 through
much of this period.
Renewed weakness in the currency began
to emerge in 1997 and became increasingly apparent
in 1998, despite strong domestic fundamentals—
very low inflation, moderate economic growth, and
solid government finances. Once again, the slide of
the currency could be partly attributed to external
80 A History of the Canadian Dollar
Introduction of inflation targets
In February 1991, the government and the Bank
of Canada set out a path for inflation reduction,
with the objective of gradually lowering
inflation, as measured by the consumer price
index (CPI), to 2 per cent, the midpoint of a
1 to 3 per cent target range, by the end of 1995.
An explicit commitment to an inflation target
provided a nominal anchor for policy, helped to
shape market expectations about future inflation,
and improved central bank accountability. The
target range of 1 to 3 per cent was subsequently
extended on three occasions to the end of 2006.
With much of the short-run movement in
the CPI caused by transitory fluctuations in
the prices of a few volatile components
(e.g., gasoline),
the Bank focuses, for operational
purposes, on a measure of core CPI inflation
that excludes eight of the most volatile components of the CPI and adjusts the rest to remove
the impact of changes in indirect taxes.
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factors in the form of lower commodity prices.
Commodity prices began to soften in the summer
of 1997 but subsequently weakened significantly,
owing to a financial and economic crisis in
emerging markets in Asia. In this regard, the weaker
Canadian dollar acted as a shock absorber and
helped to mitigate the impact of lower commodity
prices on aggregate demand and activity in Canada.
The large negative interest rate differentials
that had earlier opened up between Canadian and
U.S. financial instruments also weighed against the
Canadian dollar, as did the U.S. dollar’s role as a
safe-haven currency during times of international
crisis. Rising U.S. equity prices, reflecting a pickup
in productivity growth and large capital flows
into the high-technology sector, were another
background factor that supported the U.S. currency
against all others, including the Canadian dollar.
This factor persisted though the rest of the decade.
During the summer of 1998, the crisis in
emerging-market economies widened and intensified with a debt default by Russia and growing
concerns about a number of Latin American countries. The Canadian dollar touched a low of
US$0.6311 on 27 August 1998, before recovering
somewhat following aggressive action by the Bank
of Canada, including a 1 percentage point increase
in short-term interest rates and considerable
intervention in the foreign exchange market. While
a lower Canadian dollar was not surprising, given
the weakness in global commodity prices, the
authorities had become concerned about increased
risk premiums on Canadian-dollar assets and a
potential loss of confidence on the part of holders
of Canadian-dollar financial instruments. Interest
rate reductions by the Federal Reserve Bank and
A History of the Canadian Dollar 81
Exchange market intervention
The Bank of Canada last intervened in the foreign exchange market on behalf of the
government on 27 August 1998. Up to this
point, Canada’s policy had been to intervene
systematically to resist, in an automatic fashion,
significant upward or downward pressure on the
Canadian dollar.
In September 1998, the policy
was changed as intervention to resist movements
in the exchange rate caused by fundamental
factors was ineffective. Neither the government
nor the Bank of Canada target a particular level
for the currency, believing that the value of the
Canadian dollar is best set by the market. Over
time, the value of the Canadian dollar is
determined by economic fundamentals. Canada’s
current policy is to intervene in a discretionary
manner in foreign exchange markets only on
the most exceptional basis, such as periods
of market breakdown, or extreme currency
volatility. For more information, see the Bank of
Canada’s website at www.bankofcanada.ca.
the return of a modicum of stability in financial
markets following action by the Federal Reserve to
calm markets after the collapse of Long-Term
Capital Management (LTCM), permitted the Bank
of Canada to reduce Canadian interest rates without
undermining confidence in the Canadian dollar.93
The final year of the decade saw the
Canadian dollar recouping some of its earlier losses
against the U.S. dollar as the international financial
situation improved, and investors focused on
Canada’s strong economic fundamentals, including
a narrowing current account deficit and strengthening global commodity prices.