On Inflation, Parity and Reversed Hollowing Out

These days, Canada has become like a benign Bermuda triangle, where mysterious forces converge and yield interesting results. Prices of durables and semi-durables have been steadily falling, keeping inflation tamed, almost harmless. Our dollar has hit parity, something that hasn’t happened for three decades. And the strength of our stock markets, combined with the country’s overall increased purchasing power, has potentially shifted corporate gears from hollowing out into reverse.

According to statistics compiled by the Bank of Canada, prices of durable goods, excluding cars, decreased 13.4% in the past decade. Prices of semi-durables began decreasing a little later, in 2001, and so far have shaved off 0.8% each year.

Why? What are retailers to do when confronted by a powerful competitor, capable of manufacturing and marketing cheap products (not necessarily quality products, though)? Well, they have to lower their prices, simple as that. And who is that powerful manufacturer and distributor? No, it’s not Wal-Mart, although the retailer was certainly one of the exploited venues used by the main “culprit.” No, to make a shift in a country’s price levels, such a manufacturer would have to come from the international trade scene. You guessed it — we are talking about China!

Moving on to parity, while our loonie soars, cross-border consumer prices behave irrationally, at least with respect to economic theory. I still remember jokes my American friends and clients used to say when the loonie was trading at about US$0.62. “Why do Canadians even bother to have their own currency?” They used to say, “Take our greenback; you use it for everything else anyway.”

Unfortunately, my friends are still joking, saying that, “Even with your pompous little loonie at par, my designer shoes are still cheaper than yours… nah, nah, nah, nah, nah, nah!” As it turns out, Canadian consumers may be in for an embarrassing wait for foreign-exchange parity to filter down to prices of goods and services.

What economic law is foreign-exchange parity between Canada and the U.S. defying? It would be the law of one price, whereby identical goods should sell for the same price in two markets. If not, arbitrage opportunities exist, which, after initial imbalance, arbitrage tends to stabilize in the long run. Why are prices stubbornly refusing to acknowledge our dollar’s newfound strength? Simply, prices of finished products are far less sensitive to foreign exchange rate prices, and it takes much longer than a few trading sessions for the effects to take distinct shape and form.

While the loonie may not have caused waves among consumers, it is certainly causing waves among market commentators. Actually, only one has been pretty loud about it so far, but he is loud anyway — Jim Cramer. Cramer is an acquired taste, and while I have not yet “acquired it,” I liked his antics about the “Canadian Invasion,” prompted by Toronto-Dominion Bank’s rather daring over $8.0- billion takeover bid for Commerce Bancorp Inc.

In his Tuesday CNBC “Mad Money” show, Jim Cramer bellowed, “Citizens of Cramerica, it’s time to prepare for the Canadian Invasion. It’s not going to be as cool as the British Invasion, but it could make you more money.”

Basically, his contention is that the loonie has found the cure for Canada’s corporate hollowing out, at least in the financial sector. Canada’s banks finally have the money and strong currency to go shopping south of the border. To stay competitive in our global village, Canada’s banks need to grow through acquisitions and outside of Canada’s relatively small corporate arena. As fate would have it, there are plenty of bankers in the U.S. that are desperate for cash infusions.

So, here we are now, enjoying a strong economy, stable price levels, strong currency, strong financial markets, and some tough dudes singing our praises and making cute analogies. Canada seems to be carving an image of success in the eyes of the world, which appears both well-deserved and long overdue.