Economic analysis

Why didn’t markets see the Bank of Canada interest rate hike coming?

It would be good for everyone if Stephen Poloz and market participants could find a way to understand each other

Bank of Canada Governor Stephen Poloz attends an Empire Club of Canada luncheon in Toronto, December 8, 2015. (Chris Helgren/Reuters)

Bank of Canada Governor Stephen Poloz attends an Empire Club of Canada luncheon in Toronto, December 8, 2015. (Chris Helgren/Reuters)

Stephen Poloz still has some time to go as Bank of Canada governor, but if we were to write his legacy today, it would consist of three things. One, he cut interest rates in January 2015 before most of us realized that collapsing oil prices were going to hurt. Two, he risked housing bubbles in Vancouver and Toronto by leaving interest rates really low for a really long time so the broader economy could regather momentum. And three, he infuriated much of Bay Street by refusing to tell them clearly what he intended to do with interest rates.

“I’m not a Poloz fan,” Chris Catliff, who runs Vancouver-based BlueShore Financial, told me recently. I had simply asked what he thought about Canadian monetary policy and this is what he said. Catliff grumbled about not being able to figure out the governor. The Bank of Canada had just jolted bankers and traders awake with a series of speeches and interviews that made clear interest rates were about to rise for the first time in seven years. Catliff was fine with the plan; he just disliked the way Poloz telegraphed his intentions.

On July 12, the Bank of Canada made good on those unsubtle hints, raising the benchmark interest rate to 0.75 per cent (which the banks factored in when they raised their Prime lending rate from 2.7 to 2.95 per cent). But a promise kept probably won’t heal the rift between Poloz and the men and women he counts on to transmit his policy to borrowers. A month ago, the odds of a summer interest-rate increase were essentially zero. By last week, they had surged to over 90 per cent. That’s an unusually abrupt shift in expectations. People from Catliff’s tribe lost money because few saw the change coming.

Communications is a sensitive subject for Poloz. When he was appointed governor in 2013, many spoke highly of his ability to make the economy understandable. He created narratives with beginnings, middles and ends. But this approach has created riddles as well as solved some. Early in his tenure, Poloz talked of a “rotation” to economic growth based on exports and business investment—away from debt-enabled household consumption—that only now appears to be happening. He was proven right about the oil shock, but that legacy-defining pivot in 2015 upset a lot of people. There had been no mention of it in the rotation narrative. Critics said the central bank should have done more to prepare markets for an interest-rate cut. The central bank’s response: you should have been paying closer attention.

The events of early 2015 came up at the press conference where the governor offered something of an apology after his latest policy shift. “Things move fast,” he said. “There was a certain amount of a surprise. I understand that.” And then he defended his reluctance to take highly paid and educated financial actors by the hand. “Everyone looks at the same data,” he said. “That for us is the ideal setting, where everyone is looking at the same data and everyone has a similar understanding of what’s going on and wouldn’t be hanging on the bank’s every word.”

It might not sound like it, but this is a fairly radical position. Lots of central bankers talk about forcing investors to buy their own crystal balls, but few can resist guiding markets where they want them to go. The benefit of guidance is that it avoids instability. The downside: too much stability creates complacency of the kind that existed before the financial crisis. Poloz also values the information that can be derived from perfectly functioning markets. He learns nothing from bond prices that reflect what traders think the Bank of Canada thinks about inflation. Poloz wants to know if the traders themselves think there is upward pressure on consumer prices. So he tries to force them to think for themselves. The experiment hasn’t been going well.

Catliff says he understands what Poloz is trying to achieve, but he doesn’t think it’s possible: since monetary policy ultimately is a judgement call of central bankers, investors always will put extra weight on what they assume those men and women are thinking, even if they disagree.

That challenge was in evidence in the market’s reaction to the Bank of Canada’s recent change of tone, which began with a speech by Senior Deputy Governor Carolyn Wilkins on June 12. For months, Bay Street economists had been criticizing the central bank for failing to embrace evidence that Canada’s economy was back on track. But the markets didn’t flip until Wilkins told them to. Before she spoke, the consensus was that the Bank of Canada wouldn’t raise interest rates until the first part of 2018 at the earliest. Traders were unwilling to think for themselves.

It would be good for the rest of us if Poloz and market participants could find a way to understand each other. The value of the Canadian dollar jumped almost two per cent after the Bank of Canada released its decision, to a 12-month high of nearly 79 U.S. cents. That will irritate entrepreneurs who were working on business deals based on the prevailing exchange rate in early June. The Bank of Canada may have inspired some new critics.

To avoid more volatility, the Bank of Canada may have to accept that a central bank is not just another market forecaster, and that it needs to talk more about what it sees happening in the economy. Poloz noted that the central bank is now in the habit of using a speech between its quarterly reports on the economy to update the public on its thinking. That’s a start, but it could do more. By convention, only the governor and senior deputy governor offer substantial commentary on interest rates. That means every speech by one of the other four deputies on the Governing Council is a missed opportunity to engage.

And engagement is going to be important. The Bank of Canada offered few clues about future interest-rate increases. Poloz insisted there is no “predetermined path,” and that decisions will be made “quarter by quarter” as the data come in. “Each meeting will be a fresh page,” he said.

That means there will be ample opportunity for more misunderstandings. The dollar’s surge suggests markets anticipate more increases. That seems likely. With economic growth strong, the Bank of Canada can focus on financial stability. It has long worried about record levels of household debt, and policy makers will be inclined to wean the country off cheap credit. At least one more quarter-point increase before the end of the year is plausible because the central bank thinks inflationary pressures are building faster than it anticipated a few months ago.

At the same time, Poloz left the public with reason to wonder about how high he wants borrowing costs to rise. The central bank acknowledged that its inflation forecast is based on its understanding of how the economy worked in the past; it said there is considerable circumstantial evidence that prices could be less sensitive to faster economic growth than they used to be. The spread of e-commerce, for example, stokes competitive forces that keep retailers from raising prices, no matter the level of demand. If the underlying structure of the economy has changed, the Bank of Canada could let growth run hotter without worrying about missing its inflation target.

The central bank said it will be doing a lot of research to understand what’s going on with inflation. The path ahead will be smoother if it provides regular updates on what it is learning.

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