Why the Bank of Canada will probably stand pat on interest rates

Canada’s economy is looking frail, but another rate cut is a more drastic step than the situation calls for

Stephen Poloz and Joe Oliver at a G20 press conference in 2014

Stephen Poloz and Joe Oliver at a G20 press conference in 2014. (Mandel Ngan/AFP/Getty)

The Bank of Canada on Wednesday will announce its latest interest-rate decision. Prediction: It will leave its benchmark lending target unchanged. Canada’s economy is far from healthy. But Governor Stephen Poloz said data would guide his decisions, and the indicators he follows most closely are perking up. Economic leaders over the weekend also sent a signal that monetary policy is reaching its limits. Canada’s central bank will cut borrowing costs if necessary, but the case to do so will have to be stronger than it is today.

Let’s start with the weekend. Poloz and Finance Minister Joe Oliver met their counterparts from the Group of 20 economic powers in Ankara, Turkey. Much was made of the G20’s written pledge to “refrain” from currency devaluations. But the G20 also laid the groundwork for a return to higher interest rates. The official statement conceded that “monetary policy alone cannot lead to balanced growth,” an overdue admission on the part of finance ministers that they have been leaning on their central bankers for too long. The G20 added that the long-awaited shift to higher borrowing rates had become “more likely” in some of the richer countries.

Canada isn’t among the “advanced economies” that are getting close to raising interest rates. (That was a reference to the Federal Reserve in the United States, and to a smaller degree, the Bank of England.) But it would be odd for signatory of the Ankara statement to deploy a fresh round of monetary stimulus within days of departing Turkey. Finance chiefs use these events to gather intelligence about what is going on in the rest of the world. China apparently reassured most of the group that there was nothing malicious about its devaluation of the yuan last month. The only call to action was for governments to do more to encourage economic growth, as finance ministers acknowledged they had fallen behind on their 2014 promise to increase GDP by 2%. The global panic over China’s financial markets has turned to wariness. As long as financial markets remain relatively stable, central bankers will base their decisions primarily on domestic conditions.

Poloz and his deputies on the Governing Council conclude their deliberations Tuesday. There could be debate. Economists at National Bank Financial predicted at the end of August that the Bank of Canada will cut its policy rate to 0.25%, matching the lowest on record. “Better one rate cut too many than sorrow for not having acted sooner,” said Paul-Andre Pinnsonault. Inflation isn’t an issue: the annual rate was 1.3% in July, the lower end of the central bank’s target of 1% to 3%. Ted Carmichael, an independent economist who formerly worked at Ontario Municipal Employees Retirement System and JPMorgan Chase, notes that the output gap—the difference between current production and the level of output the Bank of Canada estimates the economy can sustain without triggering inflation—was 2.2% at the end of the first quarter, compared with 1.1% at the end of 2014. Commodity prices also are weaker than the central bank predicted in July. “Another rate cut is easily defensible,” Carmichael wrote on his blog last week.

Yet Carmichael (no relation) doesn’t think Poloz will do so Wednesday. The data could support stimulus, but they don’t demand it. The unemployment rate jumped to 7% in August, but total hours worked grew at annual rate of 2.1% in the second quarter from a pace of 0.3% in the first three months of the year. The economy added more full-time jobs.

A re-acceleration of Canada’s economy will require gains in business investment and exports. Executives are in retreat. Yet Poloz always said global demand must recover before companies will resume spending. Exports expanded in June and July after declining for for five consecutive months. More importantly, international shipments by most of the industries that the Bank of Canada is counting on to lead the export recovery are trending higher. Last year, economists at the central bank published a working paper that sought to understand the overall weakness of Canadian exports by investigating the foreign sales of dozens of industrial subgroups. The study identified 15 categories that should “lead the recovery” with the help of a weaker currency, stronger U.S. demand, or both. I used Statistics Canada’s recent report on second-quarter GDP to create graphical snapshots of the trend, starting in 2000. Only one category looked like this:

Chart showing shipments of communications and audio equipment

Five categories have cleared their pre-recession peaks, although a couple—logs and intermediate metals— appear to have run into nasty weather. Eight remain below peak their peaks, but show obvious upward momentum, like this:

Chart showing shipments of building and packaging equipment

To be sure, there is a long way to go. One could argue the distance would be covered faster with aid of another interest-rate cut. I would submit that was the rationale for the Bank of Canada’s decision to lower the overnight target to 0.5% in July. The previous export records for some of these industries may be out of reach. Global trade is slowing, limiting the power of exports to revive economic growth. Lower interest rates will do nothing but inflate asset-price bubbles if there is reduced demand for goods and services. Poloz knows this, which is why he will be judicious with the dwindling mound of gunpowder he has left.