The Bank of Canada looks prepared to fight a trade war the only way it knows how: by sticking with its focus on inflation to guide its rate decisions. But by its own admission, inflation could become a complicated target should the Canada-U.S. trade dispute deteriorate into a much bigger mess than it already is. Sadly, that’s a distinct possibility.
On Wednesday, the central bank’s top officials suggested the lessons they learned from the 2014-15 oil-market collapse serve as something of a precedent for stickhandling rate policy through a shock. At the same time, they hope they won’t have to blow the dust off that playbook again.
Wednesday’s interest-rate announcement, quarterly Monetary Policy Report and press conference left little doubt that the trade file was very much on the bank’s mind. But with the most damaging of U.S. President Donald Trump’s contemplated protectionist actions – auto tariffs, tearing up the North American free-trade agreement – still little more than threats, the bank chose to leave hypothetical scenarios aside and focus on the present. Looking at an economy running at full capacity and inflation already nudging above the bank’s 2-per-cent target, the decision to raise its key rate for the fourth time in a year was a slam dunk.
At what point would the bank start to give more weight to the trade fight? When trade actions by the two feuding countries start to put a serious dent in the bank’s inflation outlook.
Whatever else the Bank of Canada looks at when considering rate policy, its formal mandate is to pursue stable inflation of about 2 per cent. When asked what the bank might do to aid the Canadian economy if the United States followed through on its threats to impose tariffs on Canada’s huge auto sector, Governor Stephen Poloz indicated that it is prepared to fall back on that mandate to guide its actions.
“The last thing you can have happen is have inflation expectations begin to be revised upwards,” Mr. Poloz said, adding that inflation concerns “would probably dominate” the bank’s policy decisions.
But by the bank’s own admission, rate policy will not be easy if Canada’s trade troubles deepen.
In the Monetary Policy Report, the bank identified protectionist trade policies as the biggest threat to its inflation outlook, and added that those risks “have broadened and intensified.” But trade turmoil is complicated for inflation.
On the one hand, further U.S. tariffs against Canada, and further Canadian retaliation, would push up prices for the affected goods (especially in the auto sector, which is highly integrated across North America). Meanwhile, an erosion of access to the U.S. market would likely weaken the Canadian dollar. Both of these are inflationary.
On the other hand, the resulting weakening of Canadian exports, business investment and consumer demand would be a significant drag on economic growth.
“That puts monetary policy in a very awkward place,” Mr. Poloz said – dealing with rising inflation amid slowing growth. “We would have to take all that into account and see what room to manoeuvre there might be to help buffer the economy.
“But the inflation part would probably dominate that analysis.”
Bank officials are already leaning on their experience with the oil slump to guide their thinking. Remember that the Bank of Canada cut its key rate twice in 2015 during the oil shock, despite a surge in the inflation rate that would, in more normal circumstances, dictate that cuts were inappropriate.
Back then, the central bank read the inflation rise as largely fuelled by depreciation of the Canadian dollar (which stemmed from oil price declines and the rate cuts themselves). It saw the inflation as transitory, giving more weight to the disinflationary implications of the economic slowdown caused by the oil slump. In retrospect, it looks like the central bank read it right.
That may imply that -- despite the likely inflationary consequences of a potential widening of U.S. tariffs against Canada -- the central bank would see through those initial price effects and support a battered economy with rate cuts. But it would be a delicate dance, and one that Mr. Poloz acknowledged could be considerably more complicated than managing the oil shock. The last thing he wants is for the bank to lose its grip on inflation.
The best scenario for Mr. Poloz is that the trade threat simply goes away. Indeed, this possibility is a big reason the bank has continued to set aside the most severe trade risks in its economic outlook and its rate decisions, even as the public concern has escalated.
“A lot of that could evaporate if NAFTA is successfully renegotiated over the course of the summer or fall,” he said. “That to me is a very important positive risk that we shouldn’t lose sight of.”