Growing Trade May Bring Bigger Currency Swings, Poloz Says

Globalization means central banks may need larger swings in interest rates and currencies to keep inflation on track, Bank of Canada Governor Stephen Poloz said.

The influence of local economic forces may wane with trade pacts fostering global supply chains, Poloz said. Companies are also filling more orders through foreign affiliates rather than shipping goods across national borders.

“Increased integration may make it more challenging for central banks to control inflation, in the sense that doing so will require more variability in interest rates, exchange rates and the output gap,” Poloz said in a lecture Monday at Western Washington University in Bellingham.

Meeting the challenge means policy makers may tweak inflation targets, by tolerating a wider range of price swings or allowing more time to recover from a shock, the governor said. Canada has a 2 percent inflation target. Poloz didn’t give an outlook on current conditions or the bank’s 0.5 percent policy interest rate.

Canada’s economy has always depended on trade, and Poloz’s term as Governor has been shaped by the two interest-rate cuts he made in 2015 to curb damage from a slump in commodity prices.

“We cushioned the blow” with rate cuts last year, Poloz said, and “it will take three to five years for the economy to restructure itself.”

Negative Shocks

Poloz said negative economic shocks carry more prominence in an era where growth has been disappointing. He reiterated global demand is being slowed because aging populations are curbing the growth of the labor force, a key ingredient in economic growth.

The address ‘Cross-Border Trade Integration and Monetary Policy’ was a tribute to Poloz’s former colleague Paul Storer, who taught at the university and passed away last year.

The lecture reviewed decades of evidence on how increased trade changes economic conditions, often using the Nafta partners of the U.S., Canada and Mexico as an example. Here are some of Poloz’s observations on how the benefits of trade often touted by economists and political leaders who signed Nafta have turned out:

*The Canada-U.S. free trade agreement and Nafta aren’t the catalyst for trade that people expected, and even today most of the evidence for deeper integration is indirect. “Certainly, the impact of the two agreements on trade seems to have fallen short of predictions made by proponents during pre-agreement debate.”

*Global trade growth may not return to the pace seen in past decades, because some of the biggest gains from opening new markets and adding new technology have already been tapped. Companies are also reluctant to invest after the global financial crisis, Poloz said. “It is therefore reasonable to expect global trade to pick up as the world economy gathers momentum; but it seems less likely to exceed global GDP growth to the same extent as in the past,” he said.

*Canada’s weak exports may be misleading because more companies are building facilities abroad and filling orders there. “By 2013, sales by Canadian-owned foreign affiliates almost matched the amount of total exports sold from Canada, at C$510 billion versus C$573 billion, respectively. In effect, there is almost as large a Canadian economy operating in foreign countries as there is in the domestic export sector, creating jobs and GDP both domestically and abroad.”

*Central banks that don’t incorporate deeper trade ties into how they track the economy may miss important signals and make policy errors. “A central bank that relies on a model that does not take rising trade integration into account when it should do so will tend to react too gradually and perhaps insufficiently to external shocks. This would run the risk of inflation deviating from target for longer than desired.”

(Updates with comments from Poloz Q&A session.)

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