Trudeau’s Plans Key to Poloz’s Messaging on Interest Rates

  • Investors complain about mixed signals on monetary policy
  • Bank will be forced to act if fiscal stimulus doesn’t work

Will he cut or not?

Investors are complaining Bank of Canada Governor Stephen Poloz has been sending mixed signals about his interest-rate plans, sowing uncertainty by speaking about the need for stimulus while at the same time highlighting the problems with adding stimulus. The Canadian currency has see-sawed over the past week as traders try to gauge his intentions.

According to a former central bank official, here is what Poloz is likely trying to get at: If the economy worsens he’s prepared to cut interest rates, but he’s not crazy about the idea, so politicians take note.

“If they are the only game in town, and something needs to be done, then ultimately they are going to move,” said Andrew Spence, head of liquid alternatives at Scotia Institutional Asset Management and an adviser to former Bank of Canada Governor David Dodge in 2002.

Poloz, a man who began his tenure at the bank refusing to talk about fiscal policy, is now one of the biggest champions of more government stimulus, arguing he can use the help. It’s a message meant as much for lawmakers as it is for investors.

“From the Bank of Canada’s perspective, they would like to see fiscal policy carry more of the burden and my guess is when you add it all up they are waiting to see if there is any more in the pipeline coming from the fiscal authority,” Spence said.

It’s no coincidence the crossed lines of communication traders are complaining about come at a time of major change for the bank. The central element of its narrative since Poloz took over in 2013 -- that exports were poised to lead growth -- has failed to materialize. In its quarterly forecasts released last week, the bank predicted for the first time since July 2013 that exports will no longer lead a Canadian recovery.

That’s forcing policy makers to look for new drivers of growth and new stories to talk about, such as fiscal stimulus.

Trudeau’s Role

The problem here is that while Prime Minister Justin Trudeau’s Liberals have changed course toward expansionism, the scope of the current fiscal stimulus package is still relatively small and, more importantly, temporary. The Bank of Canada is forecasting an outright drag from government spending in 2018 as Trudeau begins to drain stimulus from the system.

And unless something dramatic is introduced in the government’s Nov. 1 fiscal update or next year’s budget, Poloz will still largely be the only game in town.

So right now, the central bank is indeed driving forward two different messages.

One is the effectiveness of monetary policy is waning. Unconventional tools are iffy, the transmission mechanism of lower interest rates -- particularly through exports and business investment -- are not what they used to be, and households are at peak debt levels. The economy is not too far away from long-term potential growth rates anyhow. Not to mention there are a slew of unknowns, like what will happen during the U.S. presidential election next month.

“If we were to be easing further, we’d be very close to using unconventional tools,” Poloz told lawmakers Monday. “And so that’s of course not a decision we take lightly.”

Bank’s Mandate

The other narrative is the economy clearly has a lot of excess capacity, is struggling to emerge from the oil shock, and the expected driver of growth from exports isn’t materializing. Stimulus is needed.

The kicker, given the bank’s mandate, is that the second narrative trumps the first. Since the Bank of Canada’s job is to make sure the economy runs at full capacity, policy makers will have no option but to act again, despite their reservations.

Investors are placing some bets on a cut, with swaps trading suggesting a 25 percent probability Poloz will lower his 0.5 percent benchmark rate over the next year.

“There is a possibility that the Canadian economy weakens enough that the Bank of Canada feels: ‘Well, you know what, we have to cut rates further, we have to do something,’” said Philip Petursson, chief investment strategist for Manulife Investments.

Unless of course fiscal policy takes up the slack.

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