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Bank of Canada Governor Stephen Poloz speaks during an interview in Toronto on Dec. 17, 2018.

Mark Blinch/The Globe and Mail

An all-out U.S.-China trade war could spark 1970s-style stagflation that would threaten the inflation-fighting reputation of the world’s central banks, Bank of Canada Governor Stephen Poloz warned Monday.

“That’s a no-win situation,” he said in an interview.

Mr. Poloz identified the escalating trade tensions between the world’s two largest economies as his biggest concern for the economic outlook in 2019, and expressed annoyance that the global economy is at the mercy of self-inflicted geopolitical problems.

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“It’s kind of self-created. Someone has done it,” Mr. Poloz said. “When it’s purposeful, that certainly adds another layer of frustration to my thinking.”

The Trump administration has threatened to slap 25-per-cent tariffs on virtually everything China sells in the United States by March 1 unless the two sides can reach a deal to defuse their trade differences.

Mr. Poloz warned that a much larger tariff hit would set off a combination of weaker growth and a dangerous spiral of inflation.

“We called it ‘stagflation’ in the 1970s.”

U.S. and Chinese companies can generally cope with the 10-per-cent tariffs imposed now, Mr. Poloz said. But a 25-per-cent tariff would create a burst of inflation that central banks could find very difficult to contain.

Much of the rest of the world would become “innocent bystanders” as the aftershocks of a trade war rippled across the global economy, according to Mr. Poloz.

“If you do serious damage to the global trading system, you will reduce living standards permanently,” Mr. Poloz said. “Capacity will be reduced. Productivity will be reduced permanently. And interest rates can’t do anything at all for those things.”

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The upward pressure on global prices could be compounded by currency depreciation among many U.S. trading partners, he added.

Central banks in Canada and elsewhere have spent a quarter-century convincing people they can tame inflation by raising interest rates when necessary. But all that could be put at risk if the United States makes good on its threats to impose much higher tariffs, he said.

“It would erode all that credibility that’s been built into 25 years of performance, not just for us but for many countries,” Mr. Poloz said.

“Central banks would be faced with the need to defend that inflation record, and would not be cutting interest [rates] to bolster the economy because it was slowing down. They would be much more concerned about inflation.”

Mr. Poloz said the Bank of Canada’s staff is still working on its analysis of the economic fallout from the bank’s biggest near-term worry – the recent slump in the Canadian oil market. He said the bank’s economists will present him with that analysis “later this week,” along with its assessment of the broader economy, although the findings won’t be made public until Jan. 9, when the bank releases its quarterly economic projections in conjunction with its next interest-rate decision.

Earlier this month, the Bank of Canada wound back expectations for further near-term rate increases and cautioned about the outlook for economic growth, in large part because of the severe weakness in prices for Canadian oil. Since then, prices for both heavy and light crude have recovered significantly, chiefly in response to the Alberta government’s announced plans to impose production cuts on the industry.

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“What’s interesting is that there have been no production cuts yet. There’s just as much oil in inventory as there was two weeks ago,” Mr. Poloz said. “It tells you that a lot of that market action must be quite speculative ... It looks like that [speculative] trend got broken, so that’s a positive thing.”

He said the price recovery “does complicate the analysis,” but added that the price rebound doesn’t mean the bank’s concerns surrounding the sector have dissipated.

“[Oil] revenues are suddenly higher than they were just two weeks ago,” he said. “[But] we know, of course, the more fundamental reason why Canadian prices are lower than they otherwise would be is for transportation reasons. And those have not gone away.”

Mr. Poloz is confident that this latest oil slump won’t be as severe on the economy as the oil shock of 2014-15, noting both that the price decline hasn’t been as deep as in that earlier shock, and that the oil and gas sector doesn’t have as big a share of the Canadian economy as it used to.

“From a macroeconomic standpoint, the arithmetic is going to be less than what we had [in 2014-15],” Mr. Poloz said. “But I described it as ‘material’ because it is a material decline in prices, so we have to treat it as a shock and do the analysis of it.”

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