There’s nothing quite like an oil market slump to turn Bank of Canada Governor Stephen Poloz’s thinking around. Or, maybe, to tie it in knots.
In late October, when the Bank of Canada raised its key interest rate a quarter percentage point to 1.75 per cent, the central bank sounded upbeat about Canada’s economic prospects. The economy was running very near full capacity – and might have even exceeded its sustainable capacity level, Mr. Poloz said. The conclusion of Canada’s trade negotiations with the United States and Mexico had removed a huge uncertainty hanging over the economy, clearing the way for a new wave of business investment and export growth. In light of the economic health, the bank signalled that it wanted to move rates considerably higher, and possibly faster, too.
By contrast, Wednesday’s stand-pat rate announcement was a distinct downer. The tone of confidence has been replaced by caution, even outright worry. So much so that the financial markets, upon reading the bank’s words, beat a hasty retreat from their rate-increase expectations, both for the near term and for next year as a whole.
What changed so much in six weeks? Well, in a word: Oil. For the second time in Mr. Poloz’s tenure as head of the Bank of Canada, a severe slump in prices for Alberta crude have thrown the governor for a policy-setting loop.
The last time the Bank of Canada had to deal with a severe price slump in the oil patch, at the end of 2014, Mr. Poloz’s response was to stun the markets with an utterly unexpected rate cut in January, 2015. He followed that with a second cut six months later.
Now, 2018 is not 2014, and the current oil downturn almost certainly isn’t as severe and economically damaging as that episode was. No one thinks Mr. Poloz is preparing to cut rates again to ease the economic pain of this latest slump. Yet the mere fact that the bank’s rate announcement referred to the current situation as an “oil price shock” – the same language used to describe the 2014 crude crash – underlines how this turn of events has shaken Mr. Poloz and his colleagues.
One could certainly ask what took them so long. The price for Western Canadian Select, the benchmark Alberta oil grade, has been generally in decline since summer; when the central bank issued its quarterly economic projections in October, the price was around US$20 a barrel. Yet oil didn’t even get a mention in the October rate-cut announcement. For Mr. Poloz, who has preached a risk-management approach to monetary policy from day one, this was a pretty big risk to have overlooked.
Still, the Alberta government’s decision to enforce mandatory oil production cuts to address the province’s price-crushing supply glut, which it announced last Sunday, instantly ratcheted up the concern for the central bank. Those cuts, as the bank noted in its rate announcement, will “materially” weaken output in the sector – which, in turn, will put a meaningful dent in Canada’s economic growth, especially early next year when the production cuts go into effect.
But let’s remember that oil and gas extraction and related support activities accounted for only about 6 per cent of Canada’s GDP last year. It’s big enough that we’ll feel a slowdown in the sector, but not so big that the rest of the economy can’t overcome it.
By the central bank’s own reckoning, non-energy business investment should bounce back from a sluggish third quarter, now that the uncertainty stemming from the North American trade negotiations has been removed, and the federal government has introduced tax breaks for business investments. And let’s not forget that oil has an oversized impact on the Canadian dollar – which means that even as low oil prices weigh on the energy sector and Alberta’s economy, the resulting weaker currency will help stimulate further export growth across the broader economy.
It should be noted that the Alberta government’s announcement came pretty late in the game in the central bank’s rate deliberations. There was certainly time to work itself into the text of the rate announcement, but almost certainly not enough time for any detailed analysis by the bank’s economic team.
In that context, it could be that the true goal in the bank’s shift in its message was to kick the market’s expectations for the next rate hike a bit further down the road, and buy itself some time to analyze the impact of the oil market developments and let them play out for a while. If that was the bank’s intention, it worked. The January rate hike that was previously baked into bond market prices has now effectively been pushed back to the March rate announcement.
But Mr. Poloz himself doesn’t have the same luxury of time. He has a speech and news conference in Toronto on Thursday morning, at which he will be expected to explain himself. His words over the next 24 hours will tell us just how much the second oil shock of his tenure has shaken the central bank’s economic and rate outlook.