Until yesterday morning, the Bank of Canada appeared to be succeeding in the hard but necessary job of limiting the impact of the weak dollar on Canadian monetary policy.. 

The bank was focusing instead on the outlook for growth and inflation in the Canadian economy. The bank’s long-standing policy guide, an index of monetary conditions which made the exchange rate a key factor in interest rate policy, seemed at long last to have been buried. 

Yesterday, however, the one-percentage-point hike in the bank rate showed that the old policy rules from the grave. Worse, it threatens to drag the Canadian economy under with it. If not reversed shortly, this latest rate hike all but guarantees a recession by yearend. 

Even with the most enlightened monetary policy imaginable, the sliding dollar carries a somber message for Canadians. The deteriorating economic situation in Asia is weakening world demand for goods and services. As a result, commodity prices are falling, putting pressure on Canada’s resource sector. 

Russia’s economic crisis is further unsettling world financial markets – a difficult environment for Canada and other countries that tend to rely on foreign borrowing. The weak Canadian dollar, like the sagging currencies of Australia, New Zealand and Latin America, is the result of a normal reaction on the part of the world’s investors to changing economic fortunes. 

By reacting to the falling dollar with an interest-rate hike, the Bank of Canada has taken a symptom of economic troubles and turned it into a cause of worse ones. Canada, like other countries that are seeing their currencies fall against the U.S. dollar, will still lose international purchasing power. Instead of experiencing it mainly as a fall in the exchange rate, however, Canadians now risk suffering through a deflationary slump as well. 

Like the rate hike at the beginning of the year, this latest boost spells trouble for the economy. The earlier rate hike sharply narrowed the spread between short- and long-term interest rates, slowing growth from a healthy pace then to a crawl now. Today’s hike eliminates that interest-rate spread entirely, raising the probability of a recession by early 1999. 

The most frustrating thing about the bank’s misplaced focus is that the more it weakens the economy with its defence of the dollar, the worse the medium- and long-term outlook for the dollar gets. Economic strength buoys currencies up; weakness sinks them. 

As the economy flagged in the wake of the interest-rate increases of last December and January, the deteriorating outlook for investments in Canada helped reverse the dollar’s upward bounce in the weeks immediately following the hikes and accelerated its subsequent decline. This time, currency traders seem more aware of the ultimately self-defeating nature of a rate hike: the dollar’s bounce yesterday was measurable in minutes, not days. 

The rate hike raises the chances that the dollar will continue to weaken through to the yearend. 

By again putting the exchange rate front and centre in its policy-making, the Bank of Canada has made its job harder, not easier. This latest interest-rate hike has whetted the appetites of market players, who now expect another rate hike in the near future. 

If the bank gives in again, a recession next year becomes all but certain, and the prospects for developments – strong business investment, broad-based tax cuts – that would reverse the decade-long slide of the Canadian dollar against the U.S. dollar will fade to nothing. 

Far better would be for the Bank of Canada to put stewardship of the domestic economy back in its proper place at the top of its concerns and bring short-term interest rates down again. It is time to bury the old monetary policy for good. Better it than the Canadian economy. 

Kenneth Boessenkool and William Robson are policy analysts at the C.D. Howe Institute in Toronto.