Bank of Canada Governor Stephen Poloz wants to make something perfectly clear: When the Federal Reserve starts raising interest rates, Canada’s central bank won’t necessarily follow immediately.
“The main thing people should understand is that our policy is quite capable of being fully independent, as it has been these past few years,” Mr. Poloz said in an interview at the annual gathering of central bankers and economists at Jackson Hole, Wyo., over the weekend.
Mr. Poloz’s comments followed a speech by Janet Yellen, in which the Fed chair embraced the possibility that stronger economic growth could prompt the U.S. central bank to lift its benchmark lending rate sooner than expected. History shows interest-rate cycles in Canada and the United States are highly correlated. Many investors assume there is a “reaction function” in Canada to U.S. monetary policy: Where the Fed goes, the Bank of Canada must follow.
Mr. Poloz’s assertion that he will set his own path could inform speculation on Bay Street and Wall Street about when the Bank of Canada will adjust its interest-rate setting. Most analysts assume the next move will be an increase, and that higher borrowing costs will come in the summer of 2015. Current expectations are that the Fed will lift the federal funds rate from zero at roughly the same time, or a month or two earlier.
Mr. Poloz’s comments suggest the lag between the Fed’s first interest-rate increase since 2006 and the Bank of Canada’s shift higher could be longer than investors currently expect.
A broad rethink across financial markets about the linkage between Fed and Bank of Canada policy could put downward pressure on the Canadian dollar and various short-term interest rates. Even though any change at either central bank still is believed to be many months away, investors base immediate decisions on expectations of the future. If they sense the Bank of Canada could leave its benchmark rate lower for longer, they will adjust what they are willing to pay now for Canadian bonds, the currency and other assets tied to the interest rate.
Mr. Poloz refused to discuss his timetable for adjusting interest rates in explicit terms. “In the last several months we’ve gone to some lengths to pull ourselves out of a forward-guidance setting,” he said. “We are really careful not to translate our analysis into a path for the interest rate.”
Canada’s central bank long has insisted its policy decisions are not directly influenced by the Fed’s actions, but market participants have always been skeptical. Mr. Poloz’s predecessor, Mark Carney, conceded in 2010 that there “are limits to the divergence that there can be between Canada and the United States.” Mr. Poloz acknowledged that while “theoretically” the gap between Canadian and U.S. policy rates “could be anything,” the Bank of Canada “never will be 100 per cent independent” because the Canadian and U.S. economies are so closely intertwined.
While Mr. Poloz insisted he wasn’t making predictions, he offered several reasons to explain why he would feel no pressure to reflexively follow the Fed. For one, the Bank of Canada has a head start. “It’s worth reminding people that we are at 1 per cent,” Mr. Poloz said. “In this world, that’s a high number when everything is starting at zero.”
The Bank of Canada is seeking to return its benchmark interest rate to a setting that neither stokes inflation nor hurts the economy. Before the crisis, the “equilibrium rate” was understood to be about 4 per cent. The central bank now thinks scars from the crisis have lowered that rate. “When you think the equilibrium number is at some lower rate than in the past, which I do, but I don’t know yet what it might be, then at least we know that we are part way there already,” Mr. Poloz said.
The other factor is the relative strength of the two economies. The U.S. has considerable forward momentum, while Canada still is waiting on a revival in exports and business investment. Stronger demand in the U.S. should benefit Canada’s economy. Monetary policy in the two countries is so similar because of their close trade links: When the U.S. economy grows, Canada sells more exports, which boosts economic growth and puts upward pressure on inflation.
Canada’s loss of market share raises questions about whether stronger U.S. growth will boost Canada’s economy to the extent it has in the past. Mr. Poloz says he is counting on new exporters to replace those wiped out by the recession, creating an incentive to leave borrowing costs low to help those entrepreneurs get started. Canada’s job growth this year is almost entirely driven by part-time positions, while U.S. employers are adding jobs at one of the most impressive rates on record.
“The linkage between their recovery and ours is not mechanical … We still have question marks around ours,” Mr. Poloz said. “We ought to be able to strike a fully independent course determined by these other things quite independently of what theirs are.”