Is Canada’s interest rate strategy too aggressive?

“When in doubt, increase rates.” That is what the Bank of Canada’s governors have used to describe how interest rates can drive the economy. It is a strategy that has worked. The central bank’s…

Is Canada's interest rate strategy too aggressive?

“When in doubt, increase rates.”

That is what the Bank of Canada’s governors have used to describe how interest rates can drive the economy.

It is a strategy that has worked. The central bank’s policies led to the huge expansion of the Canadian economy following the global financial crisis. By 2009, Canada had a debt-to-GDP ratio of 22.5%, the lowest of any G7 country. By 2009, it was down to 15.7%, the lowest level of any G7 country.

Now, it is time to have a conversation about how the Bank of Canada used the same tactic, and time to re-examine whether such strategies continue to be the best way to fuel the economy.

I was recently in Canada for the annual World Affairs Council of Canada meeting. There, guests were stunned by the robust economy in Canada. A lot of it is thanks to strong, female Canadian leadership.

That is to be celebrated. But one of the major drivers of Canada’s economy is its central bank governor, Stephen Poloz. And at the time he took over his job five years ago, Poloz told me he believed the central bank needed to stay vigilant about inflation.

Investors don’t often know the specifics of a central bank governor’s concerns. All they usually know is when Poloz decides to raise interest rates. The idea is to raise the cost of credit, so banks will have to lend more money to borrowers. That could boost borrowing and economic growth.

But the good news is, Poloz clearly has a higher tolerance for risks, compared to previous central bank governors, such as the recent era under Mark Carney.

“I think that, increasingly, the Bank of Canada is embracing its new governing philosophy of more flexibility,” said John Howson, an economist and Chief Economist at Capital Economics, a British investment firm.

Over the years, the Bank of Canada has had a similar inflation target. It has measured how much of a 2% increase in the price of something can lead to a 2% increase in inflation. Then it sets a target and makes the rate “coupled with the behaviour of interest rates.”

For example, in May, Poloz raised the benchmark rate by a quarter point, to 1%, which was a 50% increase from where it had been the previous few years. That’s what many investors were expecting him to do and they were surprised when Poloz didn’t do it.

Poloz said he wanted to give himself some room to maneuver because they expected economic growth to slow. In fact, most economists predicted no change. Poloz felt as if his targets were still within reach.

As Howson notes, this is not the only reason the Bank of Canada felt no need to raise rates. Before Poloz became the central bank governor, inflation was near 3% and unemployment was 11%. The U.S. central bank had had a somewhat similar problem with inflation, and when it changed its inflation target, it agreed on a 2% target that was slightly less than in Canada. In 2010, the Fed finally lifted its target to 3%.

The Bank of Canada followed suit in 2012 with a 2% target.

The Canadian approach is putting the Bank of Canada in a better position than the Fed to hold the line on rates in the event of a recession. Both of these are healthy. The current risk to the Canadian economy is higher interest rates, meaning consumers who have borrowed money on the cheap before may face higher rates. The Fed is choosing to hold interest rates, but it has a history of easing off as economic conditions improve, which could be risky for the American economy.

But if Poloz looks for change in the way he views inflation, it could mean the Bank of Canada can’t just raise rates like it did in May, and expect that to stimulate the economy as it said it intended to do. The central bank may have to temper its concerns or slow down. That would not be good news for the Canadian economy.

Poloz is giving the central bank new freedom to fight inflation. That could mean more of us keep our jobs and give consumers more confidence to borrow to spend. It could also mean higher rates could become the norm for the Fed.

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