* Would only intervene in C$ in extreme circumstances
* China must allow greater flexibility in its currency
* BoC has flexibility if Fed eases further
* G20 has the right plan, must implement it (Adds closing C$ level, further details from speech)
By Louise Egan
MONTREAL, Oct 5 (Reuters) - Volatility in the Canadian dollar is a concern for the Bank of Canada, but it would only resort to market intervention in extreme circumstances, the central bank's second-in-command said in an interview on Tuesday.
Tiff Macklem, senior deputy governor of the bank, also predicted negative consequences for the global economy if China does not allow its currency to appreciate more quickly, ramping up the rhetoric on foreign exchange policies ahead of G7 and G20 meetings this month.
Macklem spoke as the Canadian dollar, boosted by commodity prices after the Bank of Japan cut rates, jumped more than half a U.S. cent to hit its highest levels since Aug. 6. It closed at 98.30 U.S. cents.
Bouts of Canadian dollar strength have traditionally exacerbated problems for exporters, who have already been hurt by waning demand from the United States, Canada's biggest export market.
"Clearly, we absolutely need to take into account where the dollar is, why it is where it is when we take monetary policy decisions and, yes, we do get concerned about the exchange rate, particularly if it's volatile, if it's moving quickly," Macklem told Reuters in Montreal, following his maiden speech after starting his new job in July.
The Bank of Canada rarely intervenes in foreign exchange markets and has a policy of resorting to such action only if there is a near-term market breakdown or extreme currency movements that threaten the Canadian economy.
The comments by Macklem, formerly Canada's G7 and G20 finance deputy, come as a drive by many countries to cap the strength of their currencies is gaining momentum and causing tensions. [ID:nLDE69308R]
The other big threat appearing on the central bank's radar is the possibility of further easing by the U.S. Federal Reserve, widening the policy gap after the Bank of Canada raised its benchmark rate three times since June to 1 percent.
Governor Mark Carney has said recently that there are "limits to the divergence" in policy between the Bank of Canada and the Fed, given Canada's trade reliance on its neighbor.
Macklem said the bank has more flexibility to react now that it has moved away from emergency measures such as near-zero interest rates, a conditional commitment to keep rates at a low level for a specific period of time and extraordinary liquidity facilities.
"Having moved off our extraordinary conduct ... we have more flexibility," he said when asked how the bank would respond if the Fed engaged in further asset buying, or quantitative easing.
"Having said that, a 1 percent interest rate is still a
very low interest rate. Broader financial conditions remain
very expansionary and that is appropriate, given the fact that
we continue to have a very significant output gap."
For a graphic comparing Bank of Canada and G7 rates see:
http://graphics.thomsonreuters.com/F/09/CA_RATE0910.gif
Macklem said the Bank of Canada is developing models that could help it expand its mandate in the future to "lean against" financial imbalances rather than a single-minded focus on inflation targeting.
"When you get into a situation where either the financial system isn't working normally, or you get into a situation where there are distortions in the financial system, you need to look under the hood ... We need to start putting money and credit and the key institutional features of banking systems into our models, so we have started to do that," he said.
Macklem said in his speech that the issue of using monetary policy to tackle imbalances is an important one to consider as the bank approaches the renewal of its inflation-targeting mandate with the government at the end of 2011.
Under the terms of an agreement with Ottawa, the bank aims to keep inflation at the midpoint of a 1 to 3 percent range. It has been looking at possible alternatives since 2006.
But Macklem said it was not clear if the bank and the government would be ready for that change just yet.
"Clearly, as we get towards the end of 2011 and the renewal of the inflation targeting regime, there will be some decisions to be taken jointly by the government and by the BoC."
CHINA MUST TAKE MORE STEPS
The Bank of Canada has been escalating its calls for China to let the yuan appreciate more quickly and Macklem said there will likely be considerable discussions about this at upcoming Group of Seven and Group of 20 meetings.
If China does not make the necessary changes, the adjustment will be made more messily: through inflationary pressures in China and deflationary pressures in the United States, Macklem warned.
"That is not going to be good for China and the United States and it's not going to be good for the rest of us either."
G20 leaders agreed to more currency flexibility at their June summit in Toronto and should be held accountable to that agreement, Macklem suggested.
"Go back, read the agreement, its quite a detailed agreement ... I think it's the right plan."
Macklem declined to say whether he though policy makers would reach an agreement by a November summit in Seoul on a mechanism that would allow systemically important banks to fail without resorting to taxpayer-funded bailouts.
Canada has been pushing for including contingent capital, which could be converted to equity in times of distress, as a key element of any resolution regime for globally important banks.
"(The idea) is gaining traction ... it is now very much part of the main agenda," he said. (Reporting by Louise Egan; editing by Rob Wilson and Jeffrey Hodgson)