Bank of Canada keeps eye on low inflation, but no change in key interest rate

OTTAWA – Canada’s central bank raised concerns Wednesday about the country’s persistently low inflation rate, a trend that the average consumer may welcome, but could lead to bigger problems.

While it sees improvements in the domestic economy, the Bank of Canada said inflation is now expected to be lower than it had previously projected — in part because of competition among retailers.

The concern came as the Bank of Canada kept its key interest rate at one per cent, where it has been since September 2010.

Disinflation, or a slowing in the rate at which prices rise, seems to lasting longer than expected, governor Stephen Poloz said.

It’s good for consumers because it means they have more spending power, but it’s “not just the gift that it sounds like,” he said.

Central banks are usually more preoccupied with controlling high inflation, but low inflation is equally concerning because it can be evidence of weakness in the economy and could lead to deflation, where prices actually fall.

“Deflation would be defined as not just falling prices, but also falling wages at the same time, and just imagine what that would feel like with your mortgage still the same number,” Poloz said.

The bank expects the total inflation rate to remain at 0.9 per cent in the first half of 2014, down from its previous forecast of 1.2 per cent. But that should “increase very gradually” and reach the bank’s ideal target of two per cent in last quarter of 2015.

Canada’s total inflation rate was 0.9 per cent in November, the seventh month in the past 13 in which the official headline inflation reading came in below the bank’s desired range of between one and three per cent. Statistics Canada will release December inflation figures on Friday.

Inflation needs to be within the bank’s target range so there’s room to manoeuvre if there’s another economic shock, Poloz said.

“So if you are where we are today, which is significantly below target, it leaves you ill-prepared for any bad news that could happen.”

But Poloz made no move on interest rates, keeping the bank’s key rate at one per cent and maintaining a neutral stance on whether its next move will be to raise or lower the rate from where it has been for more than three years.

The bank noted that inflation in Canada is expected to “remain well below target for some time,” so the “downside risks have grown in importance.”

“The most important risks are stronger U.S. investment, underperformance in Canadian exports, and imbalances in the household sector,” it said.

Canada’s economic growth in the second half of 2013 was better than expected and should pick up from an estimated 1.8 per cent last year to 2.5 per cent both this year and next, it said. Global growth — led by stronger momentum in the U.S. — is expected to rise from 2.9 per cent in 2013, to 3.4 per cent and 3.7 per cent in the following years.

Stronger demand in the U.S., as well as the lower loonie, should help boost Canadian exports, which will also improve business confidence and investment, the bank said in its monetary policy report.

But “despite depreciating in recent months, the Canadian dollar remains strong and will continue to pose competitiveness challenges for Canada’s non-commodity exports,” it said.

That was a key phrase, said BMO chief economist Doug Porter.

“This is a strong statement for the bank, and as close as they will come to saying the currency is still overvalued and, thus, further depreciation is welcome,” he wrote in a note.

The Canadian dollar dropped 0.8 of a cent to 90.34 cents U.S. following the bank’s report, closer to lows set in early September 2009.

The currency has lost nearly four cents since Dec. 31, when it closed at 94.02 cents US, due to a combination of factors including a strengthening U.S. dollar, weak prices for commodities and Canada’s low-interest, low-inflation environment.

But when it comes to economic growth, the increase in U.S. demand is the most important thing, Poloz said.

“That’s the cake. And if the exchange rate is going down a little and gives us that little bit of a marginal boost — there’s your icing on the cake,” he said.

The bank said it will make its next interest rate announcement on March 5 and release its updated outlook for the economy and inflation — including risks to the projection — on April 16.