Poloz Sees Lasting Policy Divergence as U.S. Rates Rise

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Bank of Canada Governor Stephen Poloz said he expects a lasting divergence in policy between the U.S. and resource producers such as Canada struggling with collapsing commodity prices.

The global economy is reacting to a “seismic shift” that will generate higher incomes in resource-importing countries, while requiring lengthy economic adjustments for exporters, Poloz said in a speech Thursday in Ottawa. In fact, rising U.S. interest rates may actually act as an additional downside risk to the Canadian economy by driving up long-term borrowing costs, he said.

The remarks indicate policy makers see little likelihood that a U.S. recovery driving up interest rates there will be strong enough to help Canada quickly overcome the effects of slumping commodity prices. Policy divergence between the border nations rarely happens, since the two economies are usually in sync.

“These different reactions have divergent implications for monetary policy from country to country,” Poloz said. “Divergence of monetary policy should be expected.”

The comments are Poloz’s last before a Jan. 20 interest-rate decision, and comes as diverging monetary policy has weakened the Canadian dollar to around 12-year lows. The central bank’s 0.5 percent policy rate is close to the all-time low of

0.25 percent set during the global financial crisis, and Poloz said last month there is room to move it to negative 0.5 percent if another big slump comes.

“Financial markets have been focused on policy divergence for some time, and we should be prepared for this preoccupation to last,” Poloz said.

Cut Odds

Futures traders are placing an 18 percent chance Poloz will cut interest rates to 0.25 percent this month. At least one interest rate cut at some time this year is fully priced into swaps contracts.

Poloz reiterated Thursday that Canada’s central bank is prepared to deploy “unconventional” tools if needed to curb lingering damage from a slide in oil and other commodity prices.

“We have a number of tools at our disposal -- both conventional and unconventional -- to mitigate risks to our inflation target or to our financial system, should they arise,” Poloz said.

Thursday’s speech doesn’t provide a “smoking gun that indicates that they are thinking about cutting in January,” David Tulk, chief Canada macro strategist at TD Securities in Toronto. Still, “the speech is fairly dovish, it does talk about the tools the bank has and how it is important to think about keeping monetary policy independent as the Fed is going higher.”

The speech “Life After Liftoff: Divergence and U.S. Monetary Policy Normalization,” said the building recovery that led the Federal Reserve to raise interest rates is a “welcome development” because it reflects a strengthening U.S. economy. At the same time, the U.S. is a net beneficiary of falling commodity prices. In Canada, the commodity shock is reversing a decade-long trend in Canada and policy makers should facilitate the necessary adjustments, Poloz said.

Dollar Decline

The Canadian dollar’s decline is no surprise given the drop in crude oil prices and is needed with the commodity crash reducing incomes by C$1,500 per person, Poloz said. The gains to non-energy exports from a weaker Canadian dollar are being blunted by the depreciation in the currencies of rival commodity-producers, he said.

“This shock is leading to significant and complex economic adjustments in Canada,” Poloz said. “There is no simple policy response in this situation.”

Adjustments to such shocks can also be aided by fiscal policy and changes in labor-market rules, Poloz said. Those comments come as Prime Minister Justin Trudeau prepares a debut budget in the next few months where he’s promised deficit spending to boost growth.

Poloz said countries hurting from a commodity price drop have flexible currencies that act as “the most important facilitator of adjustment,” although that isn’t a “panacea” for a recovery.

“This is helping to offset the weakness in the resource sector tied to lower commodity prices, but this natural process will take time to translate into more investment spending and new job creation,” Poloz said.

Bank of Canada policy makers will “look through” the short-term inflation pressure created by a weaker dollar as import prices rise, Poloz said. He also said the core index of prices is overstating the true trend of inflation as the currency depreciation raises import costs.

The speech didn’t make any direct comment on the outlook for the key interest rate, and Poloz said he will revise his economic forecast in the quarterly report that comes with his Jan. 20 rate decision.

Three-quarters of Canada’s exports are to the U.S., and so far manufacturers have struggled to rebuild orders to make up for falling oil and gas receipts. Energy shipments have fallen by 40 percent in November from 12 months earlier to C$5.92 billion, Statistics Canada said Wednesday. The trade deficit from January to November of C$22.8 billion exceeds the previous comparable record of C$12.9 billion set in 2012, even with a jump in automobile production.

(Updates with analyst comment in 10th paragraph.)

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