If NAFTA fails will rates fall?
Spillover from trade wars could result in higher prices, Kevin Carmichael writes.
The Bank of Canada has a message: if the trade talks with Donald Trump collapse, don’t assume monetary policy will cushion the fall.
Carolyn Wilkins, the senior deputy governor, used a speech in Regina Thursday to emphasize a reality of central banking that probably hasn’t taken root in Ottawa and elsewhere.
The Bank of Canada’s overriding responsibility is to keep inflation safely contained within a range of one to three per cent.
It’s tempting to assume central banks will automatically drop interest rates when things go bad; they did in 2008 when the bankruptcy of Lehman Brothers triggered the financial crisis. But the Bank of Canada joined that fight because it knew a massive downturn risked deflation. Policymakers dropped borrowing costs to their lowest ever to generate enough economic momentum to keep inflation on target.
The response to the loss of preferential access to the U.S. market wouldn’t be as obvious. To be sure, if the loss of the North American Free Trade Agreement triggered a recession, the central bank would cut rates.
However, given the Canadian economy’s recent strength, a more likely spillover from the trade wars could be higher prices. Relatively strong demand would keep the economy going, but companies probably would insist on charging more to offset tariffs. That’s how inflation spreads, and the central bank would feel duty bound to stop that from happening.
“Protectionist measures create risks to the upside for inflation, especially when the economy is operating at full capacity,” Wilkins said. “In weighing these trade-offs, you can be sure that Governing Council will not lose sight of our primary mission.”
For now, though, the Bank of Canada is in no great rush to raise interest rates.
This week, policy-makers opted to leave the benchmark rate unchanged at 1.5 per cent, saying they were keeping a close eye on the NAFTA negotiations.
But Bank of Canada Governor Stephen Poloz and his deputies, which include Wilkins and three others, might have come closer to raising interest rates than most realized when they announced their decision on Wednesday. Wilkins said the Governing Council debated whether it should speed up its plan to get rates back to a more normal level. In the end, officials decided there were enough unknowns to warrant a “gradual” approach.
“We still acknowledge that there may be more room to grow without causing inflation than we have built into our forecast,” Wilkins said. “We also know that high levels of household debt have made the economy more sensitive to interest-rate increases than in the past.”
Yet the barriers to higher rates are crumbling.
Some investors have expressed alarm over the fact that the yield on longer term bonds is only marginally higher than that of shortterm debt. That’s odd because it should cost significantly more to borrow money for 10 or 30 years than for two years. In the past, when the yield curve “inverts,” a recession has tended to follow.
“The narrowing slope of the yield curve could give Governor Poloz reason to reassess the pace of policy next year if longer yields don’t realign to fundamentals,” Beata Caranci, chief economist at Toronto-Dominion Bank, said in a report last month.
“Or, conversely, the Bank may find itself spending a lot more time addressing questions related to bond market pricing and the implications it offers on the economic outlook.”
Wilkins decided to do some explaining in Saskatchewan, although the message clearly was directed at the bond traders on Bay Street.
She said the Bank of Canada agrees that the outlook for the global economy has become more complicated, but she said the Governing Council prefers a “broader range of indicators” to obsessing over the bond prices. Wilkins noted that the “curve is not currently inverted, and is therefore not pointing to significant slowing.”
She also said increased demand for longer-dated securities from central banks and institutional investors probably is causing the yield curve to send a false signal.
Overall, Wilkins’s remarks suggest strongly that the central bank is leaning toward raising interest rates next month at its next policy announcement.
The Bank of Canada reckons the economy can grow at an annual rate of about two per cent without stoking inflation — roughly the rate of growth for the past year, suggesting spare capacity has been used up. Wilkins also acknowledged that policy-makers were satisfied that households have absorbed previous interestrate increases just fine; a strong labour market and rising incomes are helping to offset higher borrowing costs and boosting consumer confidence.
“All this suggests that the economy is adjusting well and can adapt to higher interest rates,” she said.