The Bank of Canada's Next Move

by Yvonne von Jena | September 27, 2017

In a speech today, the Bank of Canada's governor Stephen Poloz elaborated on the rationale behind the BoC's decisions to raise rates this year, as well as provided meaningful insights into what to expect for rates in the coming year.

Eyes on Mr. Poloz

According to an article by the Globe and Mail, all eyes would be on this speech. It noted that the speech could be one of the most closely scrutinized of Mr. Poloz’s central-banking career. This speech comes just three weeks after a Bank’s interest-rate increase, which caught some central-bank watchers off guard and raised questions in some quarters about the timeliness of the its communications.

The speech, which is the governor's first public words since July, partly delivered what the Bank did not provide three weeks ago: An accounting of the Bank’s current assessment of the Canadian economy, and importantly, how that persuaded it to raise rates without advance warning.

Nuggets from Mr. Poloz’s Speech

Mr. Poloz's speech, entitled The Meaning of “Data Dependence”: An Economic Progress Report, provided some meaningful insights. Here are some key excerpts:

The objective of Mr. Poloz’s presentation was to provide people with “a sense of how far the economy has come and how much further it has to go, and talk about some signs to watch for along the way.” Further, he noted that the focus and preoccupation of the Bank is something it calls bringing the economy ‘home’, which is “the intersection of full capacity and 2% inflation.”

Context on the data and models used by the Bank. Mr Poloz noted, “any change in interest rates will not have its full impact on inflation for about a year and a half to two years. So, when we make our monetary policy decisions, we are less concerned about the latest inflation numbers - which are already a month old - than we are about where inflation will be in the future…. Among the financial market developments that we watch closely are movements in longer-term interest rates and the exchange rate.” He also included background about how the Bank goes about gathering data and information for its models and forecasts. “A lot of this [the Bank’s] judgment comes from conversations with people… [including] business sentiment - sometimes called “soft data” - and to gather intelligence about the real economy from business leaders [both Main Street and Bay Street, including regional input].”

On the historical view of the economy, Mr. Poloz said, “… the drop in oil prices was a significant detour for the Canadian economy…. Canada’s other exports took longer to recover than we anticipated... As a consequence, the composition of Canada’s exports has also changed since the crisis…. Monetary policy has played a key role in this adjustment. We estimate that if we had not lowered our policy rate in 2015, the economy would be roughly 2% smaller today - a difference of almost $50 billion - and there would be about 120,000 fewer jobs.”

Fiscal policy has been helpful. “Government fiscal stimulus measures also contributed importantly to growth, and this has meant a better mix of monetary and fiscal policy. Without this fiscal stimulus, interest rates would have had to have been even lower than they were. All things being equal, this would have meant even more household debt and an increased longer-term vulnerability for the economy.”

Supporting the recent rate hikes Mr. Poloz commented, “… in July, and again earlier this month, we raised our key policy interest rate. Between those two rate hikes we saw a long string of stronger-than-expected economic data, culminating in the GDP report at the end of August that showed an annual growth rate in the second quarter of 4.5%.”

In terms of looking ahead, Mr. Poloz said, “we project that business investment will be a key driver of economic growth. Given all this evidence, we could see by the beginning of summer that the economy’s adjustments to lower oil prices were essentially complete.”

The Bank still sees a lot of downside risk. “Despite the recent news about economic growth, the story of inflation in Canada over the past few years has been dominated by downside risks…. For most of the past five years, inflation has been in the bottom half of the target band…More recently, it has also reflected temporary factors such as weakness in food and electricity prices… inflation has been surprisingly soft… [which] led us to pay greater attention to forces pushing inflation down…”

What should we expect going forward regarding interest rates? Seems that it depends. Mr. Poloz said, “As we noted in our most recent interest rate announcement… recent data point clearly to a moderation in the second half of the year. Still, the expansion is becoming more broadly-based and self-sustaining, and it is important to remember that it is the level of output relative to potential that drives inflation, not the growth rate. We are in the process of developing an updated forecast for growth and inflation, and it will be published in next month’s Monetary Policy Report (MPR)…

“The appropriate path for interest rates… is very difficult to know, because there are a number of important unknowns around the inflation outlook… Accordingly, we need to keep updating our understanding of the economy in real time. That is why we say that the outlook for inflation, and therefore monetary policy, is particularly data dependent right now.” Thus to title and focus of this presentation.

Items the Bank is monitoring, which it has been monitoring for some time are:

  1. Economic capacity
  2. Technology and its impact on inflation (for example, the digital economy may be allowing goods and services to be produced and delivered more efficiently, helping to keep prices down)
  3. Wage growth
  4. Elevated household debt

Concludes Mr. Poloz, “In such an environment, we simply cannot rely mechanically on economic models. This does not mean we are abandoning our models. It does mean we need to use them with plenty of judgment, informed by data, sentiment indicators and intelligence, as we go through the delicate process of bringing inflation sustainably to target… We will not be mechanical in our approach to monetary policy.” 

What’s The Media Saying

Here are some headlines released today:

 The Market’s Read

The markets have been eager to know more. Working on the thin information in the rate statement after the last rate increase, the market seems to have interpreted the hike as a signal of a more aggressive path for interest rates in the coming months. The Canadian dollar jumped about 2 cents (U.S.) in the days after the rate announcement, and the bond market is basically pricing in one additional rate hike by next spring. However, the retreat of the currency since its post-hike rally – it has now given back almost all of those gains – is partly an indication that the markets are not so sure about the BoC’s intentions any more.