It’s the tough calls that reveal how a central banker thinks

In the absence of an obvious choice on interest rates, this decision is revealing of Stephen Poloz’s judgment

 
Bank of Canada governor Stephen Poloz
Bank of Canada governor Stephen Poloz (Sean Kilpatrick/CP)

Updates: The Bank of Canada has lowered the interest rate to 0.5%

Bay Street won’t be fooled again.

The professional watchers of the Bank of Canada were badly embarrassed by Governor Stephen Poloz’s decision to take out recession “insurance” in January.

Now, some may be getting ahead of the central bank governor, who will unveil his latest policy decision this morning. Many analysts foresee a quarter-point reduction in the benchmark rate to help escape a possible recession.

The shift occurred over the past few weeks. The data through the first half of the year was uninspiring. A weaker currency and cheaper energy have done little to lift growth, sparking talk of a mild recession. About half the economists surveyed by Bloomberg News now say the Bank of Canada will drop its benchmark interest rate a quarter point to 0.5% today.

The case for a cut would be clearer if Poloz hadn’t already done so in January. That decision took some courage as the data didn’t necessarily support it. The governor can take solace in the fact that his economists were among the first to foresee that Canada’s economy was headed for trouble in the first half of 2015.

Do current conditions demand similar boldness? The answer isn’t as clear as the shift in the Bay Street consensus suggests. Expectations of a rate cut are based on the assumption that a central bank that has said it will base policy on data will react to a series of disappointing numbers. But with borrowing costs already extremely low, policy makers also must weigh whether another reduction would achieve much at this juncture. There is reason to be skeptical that it would.

Monetary policy has direct influence on the exchange rate and borrowing costs. Canada’s problem isn’t a strong dollar or oppressive interest rates.

The currency has declined considerably since its surge to par with its U.S. counterpart.

Households have done their part for the economy, borrowing heavily to buy houses, cars and everything else that credit can buy. Their debt now is in excess of 160% of disposable income, a level that suggests consumers will be more inclined to get right with their lenders than to continue spending at their post-crisis pace.

What Canada’s economy needs is a surge in business investment. But the past few years have shown that it will take more than cheap money to coax Canadian executives to leverage their profits to the extent necessary to boost growth. Business leaders are motivated by return on investment, and for whatever reason, too few see opportunities to increase their profits in a wobbly global economy.

Avery Shenfeld, chief economist at CIBC World Markets, recalled in a commentary last week that before the Bank of Canada adopted its current policy of setting the overnight target eight times a year at scheduled intervals, the benchmark rate used to move around all the time.

The problem with that argument is that monetary policy has taken on a far greater role in the public’s imagination. Every decision is made in a spotlight. They have a direct influence on confidence and expectations about the future. Poloz believes the January rate cut cushioned the economy from the sharp drop in energy prices. But the sudden shift in policy also may have given executives another reason to bunker down. The last time rates were so low was during the financial crisis.

A cut Wednesday would leave the benchmark rate near its effective floor, reducing the central bank’s flexibility to deal with the elevated risk of financial turmoil from Europe’s vexed relationship with Greece or China’s stock-market bubble.

Nor is it obvious that Canada’s prospects are as dim as the data suggest. Demand from the U.S. suffered over the winter from unusually harsh weather. That forced forecasters to slash their expectations for growth in 2015, but those downgrades reflect past events more so than the future. Federal Reserve chair Janet Yellen continues to say the Fed likely will raise interest rates this year. A second-half rebound in the U.S. should boost Canadian exports. Employment in Canada also has held up over the first half. There is no indication the Bank of Canada need worry about deflation.

One of the more remarkable things about Poloz’s tenure has been his willingness to reveal what he doesn’t know. He has been clear that he doesn’t think the central bank’s models are entirely trustworthy; that they need to be recalibrated for the post-crisis economy. That means each policy decision demands more judgment than in the past.

Today’s decision will be a judgment call more so than any of Poloz’s decisions to date, with the possible exception of January’s shock rate cut. We are about to learn a great deal more about Stephen Poloz’s Bank of Canada.

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