Negative interest rates not in the cards

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There are a couple of things to understand about the Bank of Canada's revelation that it now considers it possible to push its key interest rate below zero – for Canada to actually have a negative central-bank rate.

First, saying it's possible absolutely doesn't mean that it's going to happen. It's not – at least not in the country's current and foreseeable economic context.

But having said that, the very notion that the theoretical bottom for the policy rate isn't zero, but a number meaningfully below that (-0.5 per cent, the bank's researchers estimate), could still play a key role in the central bank's decision-making in the next year. Not so much in setting interest rates, but perhaps in determining something even bigger: its inflation target.

The strongest evidence that Bank of Canada governor Stephen Poloz isn't contemplating the kind of negative interest rates he discussed in a speech Tuesday (entitled "The Evolution of Unconventional Monetary Policy") is that he said so – repeatedly and emphatically – even as he introduced the bank's new guidelines for using unconventional tools. He said his remarks "should in no way be taken as a sign that we are planning to embark on these policies … We don't need unconventional policies now, and we don't expect to use them."

It was such an important point that he felt compelled to repeat it, in French. He made the same point a couple more times in a press conference after the speech.

Indeed, he sounded remarkably upbeat about the Canadian economy, insisting that its recovery remained on track despite recent disappointments and further setbacks in commodity prices.

Okay, so you're a skeptic. Maybe you think the timing of a speech all about unconventional monetary weapons, at pretty much the moment when the stuff that got Canada's economy in trouble is going from bad to worse, can't be an accident. Never mind that Mr. Poloz's speech was booked long before commodities went into their latest tailspin, or that the bank published the topic of the speech well before OPEC decided to throw open its faucets in an already oversupplied world oil market, putting a new boot on the throat of Canada's huge, supine energy sector.

But even if you aren't willing to take the bank's word for it, consider how far removed Canada's economic realities are from the central banks in Europe that have taken their rates into negative territory.

The big common thread in the negative rates at the European Central Bank, and the central banks of Switzerland, Sweden and Denmark, is that all have been flirting with deflation. The negative interest rates are aimed at shocking the economy out of a disinflationary spiral.

That's not Canada's problem. The Bank of Canada's core inflation measure has been north of 2 per cent for more than a year. The overall consumer price index has been hovering around 1 per cent, but that's mostly due to the nosedive in fuel prices late last year – something that will wash out of the year-over-year numbers in the next couple of months.

The central bank estimates that the underlying inflation trend, after filtering out temporary distortions, is about 1.5 per cent to 1.7 per cent – a far cry from the zero or even negative inflation rates that the negative-interest-rate economies have been fighting. The inflation picture would have to deteriorate alarmingly before negative rates in Canada would even enter the policy conversation.

However, the Bank of Canada's new view on just how far into negative territory interest rates could be pushed could have an impact on its bigger-picture approach to inflation.

Since the mid-1990s, the bank has conducted monetary policy based on a single objective: pursuing an inflation target of 2 per cent. It does so by formal agreement with the federal government, which is renewed every five years. The current agreement expires at the end of 2016.

One of the things the bank has been considering as it approaches the renewal is whether it should raise that inflation target. Canada's aging demography means that the country's potential for growth has slowed, and that implies that on average, interest rates will be lower than they have been in the past. This presents a danger that interest rates could more frequently approach zero during cyclical slowdowns; a higher inflation target would serve to lift average interest rates higher and give the central bank more breathing room to set rates.

But now the bank is estimating that the effective bottom for its policy rate isn't zero, but rather negative-0.5 per cent. (In fact, previously the bank didn't even think it could realistically cut all the way to zero; its 2009 framework for unconventional policy had pegged the effective lower limit at 0.25 per cent.) That means the danger of bumping up against the bottom, at the current 2-per-cent inflation target, is less than the bank had previously assumed.

It's unclear whether this realization provides a sufficient comfort zone for the Bank of Canada to leave its inflation target unchanged. But the bank has said all along that it considers its bar for raising the target to be high. Its estimate of the capacity for negative interest rates just raised that bar noticeably higher.