Immediately following the government’s announcement that it would allow the Canadian dollar to float, the currency appreciated sharply, rising roughly 5 per cent to about US$0.97. It continued to drift upwards through the autumn of 1970 and into 1971 to trade in a relatively narrow range between US$0.98 and US$0.99. By 1972, the Canadian dollar had traded through parity with its U.S. counterpart. It reached a high of US$1.0443 on 25 April 1974.
The strength of the Canadian dollar through this period can largely be attributed to strong global demand, which boosted the prices of raw materials. There were also large inflows of foreign capital, partly reflecting the view that Canada’s balance of payments was expected to be less affected by the tripling of oil prices that occurred through 1973 than that of other major industrial countries, since it was only a small net importer of oil.
During the early 1970s, the dollar’s strength was also due to the general weakness of the U.S. currency against all major currencies as the Bretton Woods system of fixed exchange rates collapsed. With the U.S. balance-of-payments deficit widening to unprecedented levels, the U.S. government suspended the U.S. dollar’s convertibility into gold on 15 August 1971 and imposed a 10 per cent surcharge on eligible imports. This action followed a series of revaluations of major currencies. On 18 December 1971, the major industrial countries agreed (the Smithsonian Agreement) to a new pattern of parities for the major currencies (excluding the Canadian dollar) with a fluctuation band of ±2.25 per cent. The U.S. dollar was also devalued by 8.57 per cent against gold, although it remained inconvertible. This last-ditch attempt to save the Bretton Woods system failed. By 1973, all major currencies were floating against the U.S. dollar.
The strength of the Canadian dollar against its U.S. counterpart during this period concerned the authorities, who feared the impact of a higher dollar on Canada’s export industries at a time of relatively high unemployment. Various measures to rectify the problem were examined but dismissed as being either unworkable or harmful. These included the introduction of a dual exchange rate system, the use of moral suasion on the banks to limit the run-down of their foreign currency assets,
and government control of the sale of new issues of Canadian securities to non-residents. None of these options was ever pursued (Government of Canada 1972). However, under the Winnipeg Agreement, reached on 12 June 1972, chartered banks agreed, with the concurrence of the minister of finance, to an interest rate ceiling on large, short-term (less than one year) deposits. The purpose of the agreement was to reduce "the process of escalation of Canadian short-term interest rates” (Bank of Canada Annual Report 1972). Lower Canadian short-term interest rates and narrower rate differentials with the United States helped to relieve some of the upward pressure on the Canadian dollar.
Introduction of monetary targets
In reaction to "stagflation,” the combination of high unemployment and inflation that prevailed during the early 1970s, most major economies, including Canada, embraced "monetarism.” Based on work by Milton Friedman, who argued that inflation was always and everywhere a monetary phenomenon, it was maintained that by targeting a gradual deceleration in the growth of money, inflation could be brought under control with minimal cost. Accordingly, in 1975, the Bank of Canada adopted a target for the growth of M1, a narrow monetary aggregate, which it hoped, if met, would gradually squeeze inflation out of the system. Money growth would subsequently be set at a rate that would be consistent with the real needs of the economy, but would also ensure price stability over the long run. While appealing in theory, monetarism failed in practice. Despite the Bank of Canada hitting its money-growth targets, inflation failed to slow as expected. Monetary targets were abandoned in Canada in 1982. See page 77 for more details.
Monetary policy was also more accommodative than it should have been through this period, as the Bank of Canada sought to moderate the upward pressure on the currency and to support aggregate demand as the global economy slowed because of the oil-price shock. In hindsight, the Bank failed to "recognize the extent to which the economy in general and the labour market in particular were coming under strain” (Bank of Canada Annual Report 1980). In other words, the Canadian economy was operating closer to its capacity limits than was earlier believed. Fiscal policy was also very expansionary through this period. While the 1974–75 slowdown in Canada was relatively shallow compared with that in the United States, where policy was less accommodative, inflationary pressures intensified.
To address these inflationary pressures, an anti-inflation program, including wage and price controls, was introduced by the government in late 1975, and the Bank of Canada adopted a target for the narrow monetary aggregate, M1, with the objective of gradually reducing the pace of money growth and thus inflation. After weakening temporarily in 1975 and falling below parity with the U.S. dollar, the Canadian dollar recovered in 1976. Wide interest rate differentials with the United States provided considerable support for the currency, with provinces, municipalities, and Canadian corporations borrowing extensively in foreign capital markets. Foreign appetite for Canadian issues was enhanced by the removal in 1975 of the 15 per cent federal non-resident withholding tax on corporate bonds of five years and over. Foreign borrowing helped to mask the effects of deteriorating Canadian economic fundamentals on the Canadian dollar.
(Canada, $1, Trudeau just-a-buck, 1972
This example of "political currency” satirizes former Prime Minister Pierre Trudeau and was circulated during the campaign of 1972 prior to his second term in office.)
The currency moved up to the US$1.03 level during the summer of 1976 in volatile trading, but the election of a Parti Québécois government in Quebec on 15 November 1976 prompted markets to make a major reassessment of the Canadian dollar’s prospects. Political uncertainty, combined with softening prices for non-energy commodities, concerns about Canada’s external competitiveness related to rising cost and wage pressures, and a substantial current account deficit, sparked a protracted sell-off of the dollar.
Over the next two years, the Canadian dollar fell significantly, declining to under US$0.84 by the end of 1978. This occurred even though the U.S. dollar was itself depreciating against other major overseas currencies and despite considerable exchange market intervention by the Bank of Canada on behalf of the federal government to support the Canadian dollar. To help replenish its international reserves, the federal government established a US$1.5 billion stand-by line of credit with Canadian banks in October 1977. This facility was increased to US$2.5 billion the following April. A similar US$3 billion facility was organized in June 1978 with a consortium of U.S. banks. The federal government also borrowed extensively in New York and in the German capital market to assist in financing the current account deficit and to support the currency. The Bank of Canada tightened monetary policy through 1978, with the Bank Rate rising by 375 basis points to 11.25 per cent by the beginning of January 1979. Early in 1979, the federal government undertook additional foreign borrowings, this time in the Swiss and Japanese capital markets.
Notwithstanding the tightening in monetary policy, inflation pressures did not abate, even though the rate of monetary expansion was kept in line with announced targets, and the Bank Rate touched 14 per cent by the end of 1979. Against this backdrop, however, the Canadian dollar steadied and ended the year close to US$0.86.