Loonie threat eases
By Peter Diekmeyer • Bankrate.com

Occasionally, events unfold that provide an excellent glimpse into how the Canadian economy works. For example, the loonie's upward drift during the first three weeks of October and its sharp pullback following that clearly demonstrate the power of central bankers.

The story is of particular interest to housing sector stakeholders because of the strong link between foreign exchange rates and the Bank of Canada's interest rate policy, which influences many homeowners' single-largest expense -- their mortgage payments.

The importance of exchange rates
A chart of Canada-U.S. exchange rate moves during October looks remarkably like an upside down "U." At the start of the month, the loonie was trading in the 93 cents US range. Two weeks later, it had gained four cents, part of an even longer-term trend that saw the loonie rise by close to 25 per cent since its 77 cents US range March lows.

In many ways, the loonie's recent strength should not come as a major surprise. In fact, much of that strength is due to the greenback's weakness. The U.S. government has been running massive fiscal deficits in order to breathe life into its economy, and the Federal Reserve has been fanning the flames by printing money to help the process along.  International investors worry this will increase U.S. inflation, and are thus turning away from the greenback. This trend increases the relative strengths of the currencies of countries that have been outperforming the U.S., including Canada.

However, the spike's quickness, particularly the widespread talk that the loonie could soon trade at parity with the greenback, sent shockwaves through board rooms and politicians' offices. Canada's economy is heavily dependent on exports, which typically equal more than 30 per cent of its economic output in any given period. However, the lion's share of those exports end up in the U.S. As one economist noted, any rise in the Canadian currency makes our products less competitive down south, which ultimately costs jobs.

"With the loonie close to parity just a few short weeks before the beginning of the holiday shopping season, the rest of fall 2009 could well look like that of 2007," said Sebastien Lavoie, an economist with Laurentian Bank Securities. "Back then, price comparisons by Canadian consumers and a huge increase in cross-border shopping forced local retailers to sharpen their pencils and cut prices."

Carney speaks
The loonie's rapid rise forced the hand of Mark Carney, governor of the Bank Canada. "Heightened volatility and persistent strength in the Canadian dollar are working to slow growth," said Carney in the wake of the central bank's Oct. 20 interest rate announcement. Markets took those comments seriously.

Despite the fact that its policy rate is near zero, the Bank of Canada continues to have plenty of tools in its arsenal to loosen the money supply and thus indirectly bring down Canada's exchange rates. These include the possibility of instituting quantitative easing (the purchase of short-term assets). As a result, during subsequent days, the dollar slipped right back down to the 93 cents US level near where it started the month.

It's difficult to measure the effect of all of this on the housing sector because October data will only be released by the middle of November. However, the trend looks good. According to the Canadian Real Estate Association, a record 135,182 homes traded hands during the third quarter of 2009. That's a staggering 18 per cent increase from the third quarter of last year.

Not surprisingly, sellers emerged the big winners from all of this. The average selling price of homes that traded hands during September 2009 increased by 13.6 per cent compared to the same period last year to $331, 602.  But according to the Canada Mortgage and Housing Corporation, builders were slow to take advantage of the momentum. Housing starts eased slightly to 150,100 units on a seasonally adjusted basis in September from 157,300 units the month before.

Continue importance of central bankers' comments
One big lesson to be drawn from the October exchange rate fluctuations is the scale of Bank of Canada's continuing influence. With the central bank's policy rate near zero, there had been some talk that the bank could no longer cut rates at will, which would deprive it of the ability to direct events as well as it once did.

However, the fact that Carney's mid-month comments completely reversed exchange rate pattern shows that those worries appear to be unfounded for the time being. They also give reason to all of those traders who parse every sentence that central bankers say.

The Bank of Canada's next interest rate announcement will be made on Dec. 8.

Peter Diekmeyer is Bankrate.ca's economics columnist.