Policy options mostly exhausted, the Bank of Canada bets on charm

Having cut interest rates in January and July, Stephen Poloz and co. have to send their signals in other ways

 
Bank of Canada deputy governor Carolyn Wilkins, left, with governor Stephen Poloz
Bank of Canada senior deputy governor Carolyn Wilkins, left, with governor Stephen Poloz. (Sean Kilpatrick/CP)

Bank of Canada Governor Stephen Poloz sees himself as the captain of a team of policy makers, not the chief decider. He offered some symbolic evidence of that Wednesday after he and his deputies on the Governing Council opted to leave the benchmark lending rate unchanged at 0.5%. At the press conference that followed, Poloz had his assistant captain read the opening statement, a moment in the spotlight that usually is reserved for the governor. Carolyn Wilkins, the talented, yet underexposed, senior deputy was given the first opportunity to explain why a weaker outlook for economic growth in 2016 may not be as bad as it seems. “Canada’s non-resource economy is doing much better,” she said, adding later that “the bottom line is that economic momentum is building in Canada.”

Before taking questions, Wilkins turned to her boss and asked if he had anything to add. It turned out he did. In what appeared to be unscripted remarks, Poloz reminded those watching that it takes six to eight quarters for an interest-rate adjustment to affect the economy. So the Bank of Canada’s quarter-point cuts in January and July have yet to work all of their magic. “We probably haven’t seen half the effect of those cuts,” he said. “We need to be patient and let monetary policy do its work.”

These maneuvers and messages may seem inconsequential. They aren’t. The Bank of Canada’s new challenge is maintaining confidence in Canada’s economy and all it has to work with at this stage are words and symbolism. Policy is no longer an option, at least under current conditions. The central bank noted in its statement that “financial vulnerabilities in the household sector continue to edge higher,” which is the Governing Council’s way of saying that ultra-low borrowing costs continue to put upward pressure on asset prices and personal debt. That’s a constraint on another interest-rate cut. Policy makers retain the means to lower borrowing costs, but the outlook would have to deteriorate markedly at this stage before they would be willing to do so.

And as the comments above indicate, the Bank of Canada foresees growth, not decline. However, speed is an issue. The central bank predicts that gross domestic product will increase 1.1% this year, the weakest gain outside a recession in more than two decades. The expectation for 2016 is 2%, compared with 2.3% in July. Commodity prices are severely depressed, and that’s taking a larger-than-expected toll on business investment. The output gap—the difference between the level of GDP the economy can produce without triggering inflation and what it actually is producing—widened in the first half of the year; the Bank of Canada now says it will close in the middle of 2017, rather than in the early part of that year. In other words, Canada’s economy likely is 18 months away from a return to normal.

One more thing: normal isn’t what it used to be. The inflation-triggering rate of growth is called “potential.” Canada’s potential growth rate could be as low as 1.4%. That means policy makers may have to raise interest rates sooner than they have in the past to keep prices in check.

That’s not the kind of economic assessment that causes animal spirits to rush out and play. Yet the outlook isn’t terrible. The Bank of Canada’s shock interest-rate cut in January was prescient, as was the one in July, given that commodity prices have remained depressed. “They helped cushion the blow on the economy from the commodity-price shock, which is of course better than reacting after the fact,” Poloz said Wednesday. Non-energy exports are coming back to life. Bank of Canada economists have been tracking exports at a granular level, watching some 4,000 products under 31 categories of goods and services. Their latest calculations show that about half of the categories exhibit “upward momentum,” while their finer analysis reveals that Canadian exporters are shipping products that either had disappeared or didn’t exist before the crisis. This suggests companies are adapting. The Bank of Canada also noted in the Monetary Policy Report that the population of firms is starting to grow, a necessary condition of stronger potential economic growth. Increased demand from the United States, Canada’s main trading partner, and a weaker currency are making a difference.

The Bank of Canada isn’t alone in its optimism. “The Canadian economy is performing better than a lot of people give it credit for,” Brian Porter, chief executive officer of Bank of Nova Scotia, told me in an interview in Lima, Peru earlier this month. “We see businesses investing in plant and equipment and doing what companies do to expand their business.” Poloz would benefit from more testimonials like that. To achieve his mandate of inflation of around 2%, he needs faster economic growth. It would be irresponsible to play down the negatives, and he hasn’t done so. But he also is fighting against the human tendency to focus on the negative. The central bank’s message to business: it is safe to come out and invest. Just be prepared to wait for a significant return on that investment. The economy isn’t what it used to be.

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