If you were Stephen Poloz, would you raise or lower interest rates?

A primer on interest rates, plus! — a poll

Adrian Wyld/CP

Click here to read the text of Governor Poloz’s prepared remarks before the House of Commons Standing Committee on Finance.

Newly minted Bank of Canada Governor Stephen Poloz will be answering questions from MPs Thursday in his first testimony before the Standing Committee on Finance. There have been a few photo-ops, but so far we haven’t heard much from our new central banker. This is Poloz’s first chance to give us a hint of what he has in mind for Canada’s monetary policy. The question that’s on everyone’s mind, of course, is: Which way will interest rates go? The next interest rate announcement until July 17 but everyone will be looking for hints tomorrow that indicate which way the BoC’s new boss is leaning.

The Bank of Canada sets the so-called policy rate, which is the average rate the BoC wants to see banks using when they lend money to each other overnight. The key policy rates influences commercial interest rate, such as those charged by mortgages providers, and has been set at one per cent since September 2010. Anyone who remembers where interest rate were in the 1980s—which wouldn’t be this correspondent—knows how incredibly low one per cent is (in 1981 the BoC was at one point charging over 20 per cent interest on loans to other financial institutions). But interest rates throughout the developed world are at rock bottom right now. Central bankers slashed them during financial crisis to encourage borrowing and investment—and, in the U.S., likely also to limit homeowners’ defaults. The fact that they’re still so low is a testament to how slow the global recovery has been.

Interest rates, though, aren’t just the cost of borrowing: They’re also the reward that savers get for lending their money (a reward has been dreadfully small for quite a while now). Generally, raising interest rates attracts capital because some investors will move some of their money to where they can get better returns. Higher interest rates in Canada means that there will be more demand for the Canadian-dollar assets, which increases the price of the loonie relative to other currencies. An appreciation of the Canadian dollar, in turn, makes Canadian exports less competitive.

Now, an actual interest rate raise would be quite a bold move considering that the global economy is still sputtering, meaning that demand for Canada’s exports is rather weak. On other other hand, lowering the policy  rate could be equally risky, as it might further encourage borrowing at a time when Canadian household owe $1.65 for every dollar of disposable income and housing prices are at record highs.

Poloz’s predecessor, Mark Carney, kept the policy rate unchanged for almost three years but had long been promising that the Bank would eventually raise rates, something economists call “a tightening bias.” Poloz’s choice, then, many economists suggest, is really between maintaining Carney’s tightening bias and eventually hiking up rates in late 2014 or early 2015, or removing that bias and keeping rates where they are for the foreseeable future.

What would you do? Take a our survey at the bottom of this page! To help you make up your mind, below is a list of recent economic data and studies that could be as reasons to maintain the bias or to drop it. (They’re by no means exhaustive lists.)

Reasons for keeping the tightening bias:

  • Consumers are still piling on debt, according to the latest statistics, but at a slower pace. The BoC’s promise that interest rates will eventually rise might have contributed to moderate borrowers.
  • Canada has the third most overvalued housing market in the world, according to a recent OECD study that measured residential real estate prices against both incomes and rents. Ottawa tightened mortgage rules last year in an attempt to cool the market, but similar rounds of tightenings have only temporarily discouraged home buyers in the past.
  • Raising the cost of borrowing (higher interest rates) has a cooling effect on economic growth, whereas lowering interest rates is generally an economic stimulus. Now, Canada’s economy grew at 2.5 per cent of GDP during the first three months of 2013, faster than expected. Why add stimulus now by eliminating the tightening bias, supporters of the status quo might say?
  • Exports to the U.S. are growing, thanks in no small part to the housing market recovery down south.
  • Keeping interest rates low for very long periods can channel capital to the wrong corners of the economy, as investors turn to risky investments in order to earn some decent returns, argues a recent paper (pdf) by the C.D. Howe Institute. Low-for-long rates might also end up bankrolling “zombie companies,” i.e. uncompetitive enterprises that would not survive if the cost of borrowing was higher and suck up resources that should go to worthier firms, the study says.

Reasons for dropping the tightening bias:

  • April was the 16th consecutive month in which Canada recorded a trade deficit. Exports to the U.S. might well be recovering, but our exports to the rest of the world took a dive, the latest data from Statistics Canada shows.
  • With consumers maxed out and the housing market cooling, exports have been the main source of growth in the first quarter of 2013.
  • Canada might have well recorded decent growth between January and March, but it good to remember that GDP expanded by a dismal 0.9 per cent in the last quarter of 2012. If the U.S. economy slows as a result of the automatic spending cuts approved by Congress and the White House earlier this year, Canada might follow.
  • House prices might still be very high, but home sales have generally been declining after Finance Minister Jim Flaherty further tightened mortgage rules a year ago. It could be a sign that the government’s efforts are working this time.

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