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The thinking behind the Bank of Canada’s latest policy statement

Kevin Carmichael explains why the bank is just fine with a weaker loonie


 
Stephen Poloz on the Hill in April 2015 (Justin Tang/CP).

Stephen Poloz on the Hill in April 2015 (Justin Tang, CP).

It is difficult trying to discern what Bank of Canada Governor Stephen Poloz really thinks about the exchange rate. Officially, he is agnostic. “The dollar is what it is,” Poloz said during testimony at the House of Commons Finance Committee on April 28, 2015. “No one, certainly not us, pins an industrial strategy on a weak currency.” Not an industrial policy, but perhaps a stimulus drive? “Oh, absolutely,” Poloz exclaimed earlier at that same committee appearance when asked if a weaker dollar was a net benefit to Canada’s economy. “Historically, it’s been a significant net benefit.”

So it would be unfair to call Poloz a currency manipulator: he has dropped Canada’s benchmark interest rate to within a quarter point of its record low because otherwise inflation would drop below 1 per cent, the low end of the Bank of Canada’s comfort zone. (It aims to keep prices increasing at an annual rate of 2 per cent, with a cushion of 1 percentage point on each side of that target.) However, it would be fair to deduce that Poloz is unmoved by arguments that a weak currency hurts Canadian business by making it more expensive to import cutting-edge technology and to expand overseas. “The entire calculus of the firm is affected by that exchange rate, but the most important thing is that it makes those companies more competitive when competing for new contracts,” Poloz said. “Existing contracts, which are already negotiated in U.S. dollars, yield a big increase in Canadian dollar revenue in those early months of that lower dollar.”

Why the trip back in time? Because the exchange rate likely factored in much of the thinking that went into the wording of the Bank of Canada’s latest policy statement. The document was short; a mere 354 words. But those words were utilized to full effect. The Governing Council called the economy’s adjustment to the collapse of oil prices “uneven” and that business investment and intentions to invest remain “disappointing.” It surprised no one that the central bank opted to leave the benchmark interest rate at 0.5%. That likely is where it will stay until at least 2017. Laurentian Bank thinks rates are on hold until sometime in 2018.

Some pundits noted the statement said nothing about non-energy exports, which are fundamental to any chance Canada has at breaking out of its current slow-growth funk. New orders are necessary to coax executives of factories and service providers to expand, completing the rotation away from household spending that Poloz has been anticipating since he took on his current job three years ago.

There is no point waiting for oil and gas to lead Canada’s economy again. Global oil prices topped $50 (US) per barrel on May 26 for the first time in six months. That’s nowhere near high enough to inspire new investment in Northern Alberta, one of the world’s most expensive places to mine crude. And as the Bank of Canada noted in its policy statement, prices are higher in part because of supply disruptions, including the Alberta oil sands. The damage and production shutdowns caused by the wildfire that razed Fort McMurray could subtract more than a percentage point from economic growth in the second quarter, the central bank said. The losses should reverse themselves in the third quarter, as Fort McMurray begins to rebuild and oil producers resume processing bitumen. The fresh supply of oil will damp the recent price increase.

The Bank of Canada didn’t need to talk specifically about the prospects for non-energy exports; it provided an assessment of the U.S. economy, which is essentially the same thing. Canada’s central bank shrugged at America’s meagre 0.5% annual rate of economic growth in the first quarter, saying strong hiring points to a “solid” 2016. That is as good as saying Canadian exports will be solid as well. Another sign that the U.S. economy is doing well is the increased likelihood that the Federal Reserve will raise interest rates this summer, and perhaps as early as June. Some bemoan the potentially disruptive effect of higher U.S. interest rates. Poloz embraces the prospect, as he interprets it as a sign the economy of Canada’s largest trading partner is doing well.

And that brings us back to the Canadian dollar. Conditions would have to take a terrible turn to cause the Bank of Canada to cut interest rates at this stage. In its latest statement, it said “household vulnerabilities have moved higher,” which is how policy makers describe the troubling nexus between excessive housing prices in many cities and record levels of household debt. The last thing Canada needs is another incentive to buy houses in cities such as Vancouver and Toronto.

But there still is a need for stimulus. Much of that will come from Prime Minister Justin Trudeau’s infrastructure plan. Poloz also believes that stimulus will come from a weakened dollar. As the Fed raises rates, the gap between Canadian and American borrowing costs should widen, which would put downward pressure on the value of the loonie. By emphasizing the weakness of business investment, the Bank of Canada is reminding traders that it has no intention of following the Fed. Poloz may not actively seek a depressed exchange rate, but he is comfortable with one.


 

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