Stephen Poloz downplays inflation risk, seeks more growth

Bank of Canada's governor charts a data-driven path on steady rates

Bank of Canada Governor Stephen Poloz speaks about the Financial System Review during a news conference in Ottawa, Thursday,June 9, 2016. (Adrian Wyld/CP)

(Adrian Wyld/CP)

There are reputable economists who believe the business of raising and lowering official interest rates should be automatic, based on economic conditions and little else.

Bank of Canada Governor Stephen Poloz is not one of them.

Canada’s central bank opted against raising interest rates on Oct. 25, deciding that two quarter-point increases over the summer are enough for now. “The economy is expanding inflation-free farther than what many people thought when it began,” Poloz said at a press conference. “If you nipped it in the bud, wouldn’t you regret it afterwards?”

READ: Even as Canada’s economy booms, prices are barely rising

Some investors were unprepared for the central bank’s let-it-ride attitude. The dollar fell a cent against the U.S. currency as traders realized the odds of another interest-rate increase this year had become remote. Economists at National Bank advised their clients that they no longer thought borrowing costs would next change in December. Their new call: January.

Inflation is what matters most for the Bank of Canada, whose primary job is to keep prices stable, something it defines as annual price increases of about two per cent. The Consumer Price Index (CPI) has been below that mark for quite a while now, and it likely will remain shy of the target for some time yet. Meanwhile, a stronger dollar is both curbing exports and making imports cheaper, exerting downward pressure on prices. The central bank now estimates that it will be the second half of next year before the CPI touches 2 per cent, a “little later” than expected when the central bank previously updated its forecasts in July.

Still, central bankers must always be looking ahead. It takes more than a year for a change in the benchmark interest rate to affect borrowing decisions, so to contain inflation, Poloz and his deputies on the Governing Council must raise interest rates before the CPI actually touches two per cent. That’s why some economists think the Bank of Canada is playing with fire. Their profession has ways of anticipating where inflation is headed, and virtually all of their models and rules-of-thumb suggest Poloz should be raising interest rates without delay.

Gross domestic product is now forecast to expand 3.1 per cent this year, compared with an estimate of 2.8 per cent in July, according to the central bank’s new outlook. That’s pretty fast for a mature economy like Canada’s. In fact, it’s about twice as fast as the central bank reckons the economy can grow without maxing out existing production limits and sparking inflation. Another standard measure of the economy’s ability to grow without putting upward pressure on prices is the “output gap,” which is the difference between current GDP and the non-inflationary level of output. According to the Bank of Canada’s new forecast, Canada’s output gap is already essentially closed.

WATCH: Milos Raonic explains interest rates

The dollar’s big drop on Oct. 25 could be evidence that market participants finally are catching up to Poloz’s way of thinking. I’ve written a lot this year about the unwillingness of many on Bay Street to accept that Poloz isn’t going to take them by the hand and walk them down a well-marked, interest-rate path. If the Bank of Canada has been unclear in communicating that message (it hasn’t been, in my opinion), then no one can reasonably accuse it of poor communications now.

“While less monetary policy stimulus will likely be required over time, Governing Council will be cautious in making future adjustments to the policy rate,” the policy statement said. “In particular, the bank will be guided by incoming data to assess the sensitivity of the economy to interest rates, the evolution of economic capacity, and the dynamics of both wage growth and inflation.”

That’s a little jargony, but hardly impenetrable. Quick translation: interest rates are headed higher, but not as fast as they have in the past when economic growth has been strong.

The second part of that quotation sets out the factors that will determine policy over the months head. The Bank of Canada made a point of stressing that it thinks a stronger economy will pull more Canadians into the workforce, which should add to the economy’s ability to produce more inflation-free growth. Wages are rising at about the same pace as inflation, which is weak by historical standards, and suggests that households have limited spending power. Policy makers also are worried that a decade of ultra-low borrowing costs has made Canadians extra-sensitive to interest-rate increases, which could force the central bank to take a slower path back to normal.

Rules designed for different times can’t be trusted to fully capture the idiosyncratic nature of economies wrecked by the Great Recession. That’s why the Bank of Canada will be taking things slow. “Nothing is automatic,” Poloz said. “There is no predetermined path.”


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