How globalization is changing the game for central banks

With companies more exposed than ever to international markets, central banks are finding it harder to meet their targets

Bank of Canada Governor Stephen Poloz

Bank of Canada Governor Stephen Poloz. (Justin Tang/CP)

Last month, I wrote about the too-little-too-late boomlet in popular commentary on the Bank of Canada’s mandate review, the most underreported Canadian business story of 2016. There was grumbling after. Some thought I was unnecessarily mean to the press corps. Others thought my suggestion that the House Finance Committee pay closer attention to monetary policy risked the central bank’s independence.

Nuance is the first to go when it comes time to fit an argument to a page, so apologies if I hurt anyone’s feelings or left the impression that I would like to see Finance Committee Chairman Wayne Easter get a seat at meetings of the Governing Council. My intent was to make the point that the public deserves a far livelier opportunity to debate monetary policy than it has been getting of late. I thought I would return to the subject because there is yet more evidence that the business of central banking is changing. In case you missed it, Bank of Canada Governor Stephen Poloz on September 26 delivered an important lecture on trade and monetary policy. Poloz avoided definitive conclusions, but he said enough to make it clear that the country’s most prominent economist is uncertain he can continue to rely on the lessons his university instructors taught him.

On October 5, Statistics Canada will release trade data for August. Economists and reporters will seize on non-energy exports because those are what the Bank of Canada is counting on to revive economic growth. But the StatsCan figures will present only a partial reading of the engagement of Canadian companies with the rest of the world. In that lecture at the end of September, Poloz noted that the sales of the international affiliates of Canadian companies are almost as large as the country’s exports. That matters. If Canada’s companies are doing as much business in other countries as they are at home, they will be less sensitive to changes in domestic interest rates and to the value of the Canadian dollar. In other words, in a highly integrated global economy, central banks may struggle to orchestrate the outcomes they want.

Poloz offered other observations on the them. He presented evidence that globalization has caused incomes to disperse, creating greater numbers of richer people and poorer people, and reducing the size of the middle class. That’s significant because the rich and the poor are the least likely to change their behaviour after an interest-rate change: poorer people are simply trying to survive regardless of the cost of money; rich people will continue to buy and invest at will.

All of this raises the possibility that standard monetary policy no longer applies. Research by the Bank of Canada that Poloz unveiled in his lecture suggests that if Canada’s companies have spread out across the globe, rather than simply doing the bulk of their work at home, then the domestic economy will be much less responsive to subtle changes in borrowing costs and the exchange rate. If that’s true, the central bank would have to induce more dramatic changes in interest rates and the value of the currency to achieve its inflation goal.

Poloz was noncommittal about specifics, but he said the findings could mean that the Bank of Canada might have to tolerate wider misses of its inflation target. (The central bank currently is satisfied if inflation stays within a range of 1% to 3%.) Or, it might have to accept that it could take longer to get inflation back to 2% after a recession or some other shock. “A central bank that relies on a model that does not take rising integration (of the global economy) into account when it should do so will tend to react too gradually and perhaps insufficiently to external shocks,” Poloz said. “This would run the risk of inflation deviating from target for longer than desired.”

In the September column cited above, I argued that instead of extending the Bank of Canada’s mandate for the customary five years, Finance Minister Bill Morneau should go for a shorter period. I suggested this because there has been a sudden burst of doubt about the efficacy of a 2% inflation target, which is effectively the industry standard. This doubt exists among academics and practitioners. John Williams, the influential head of the Federal Reserve Bank of San Francisco, said in August that the Federal Reserve may need to raise its inflation target. That is one of the questions the Bank of Canada is considering in its mandate review. A public debate led by the House Finance Committee would strengthen the central bank’s credibility by showing all possibilities were considered. It’s difficult to see why that would be a bad thing when the governor of the Bank of Canada himself seems unsure that the current policy setup is the right one for the times in which we live.