In the US and in Europe, there’s good reason to worry about a 1970’s-style oil-price-induced negative supply shock that slows economic growth, but which also puts upward pressure on prices. This is why the Fed and (albeit to a lesser degree) the ECB have such a difficult job these days.

The Bank of Canada’s job is easier, since Canada is an important net exporter of oil. The appreciation of the CAD attenuates the supply shock in the following ways:

• A 40% appreciation in the Canadian dollar means that oil prices in Canada have risen by 40% less than in the US.
• The CAD appreciation has led to a reduction in the costs of other factors of production, notably machinery and equipment. Since 2002, the GDP deflator has risen by about 20%, but the deflator for machinery and equipment has fallen by 20%.

For policy purposes, it’s probably not a bad approximation to treat the increase in the prices of oil and  other commodities as having a neutral effect on aggregate supply. This makes it easier for the Bank of Canada to focus on inflation when it makes its interest rate decision tomorrow. And now that core inflation has surged above the Bank’s target, we should be expecting an increase in interest rates.