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Economic Insight Why Poloz may use words to cool the 'Trump effect' on interest rates

Bank of Canada Governor Stephen Poloz speaks during a news conference in Ottawa on October 19, 2016.

CHRIS WATTIE/REUTERS

Despite signalling over the fall that it had inched toward an interest-rate cut, the Bank of Canada doesn't look prepared to take that plunge in this week's rate announcement. The key question is what the bank will communicate about how far it has pulled back from the edge.

The Bank of Canada will issue the last of the year's eight scheduled rate decisions on Wednesday morning, and it now looks overwhelmingly likely that the bank will hold its key rate steady at 0.5 per cent, where it has sat for the past 16 months. The bond market is pricing in just a 3-per-cent chance of a rate cut – a pretty definitive declaration that it's off the table.

This just seven weeks after Bank of Canada governor Stephen Poloz divulged, in his opening statement at a news conference in mid-October, that the bank had "actively discussed the possibility" of a rate cut. It had just slashed its growth and inflation outlook and pushed back its projection for the economy to return to full capacity to mid-2018.

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At the time, Mr. Poloz indicated that the only thing standing between the bank and a rate cut was an unusually high degree of uncertainty about its downgraded forecast. The bank had a long list of unresolved questions – such as the effects of the federal government's new mortgage rules and its infrastructure spending program, the trend for exports and the outcome of the U.S. presidential election – and wanted to wait for more clarity.

Yet as time has passed, it has looked less and less like the Bank of Canada was seeing enough clarity to tip the scales in favour of a cut. The bond market's odds of a cut at either the December rate decision or the one in January have gone from 30 per cent in September, when the bank first started warning that it would have to lower its economic forecasts, to 25 per cent after the October rate decision and near zero today.

Mr. Poloz confirmed that sentiment at a news conference last week in Toronto. He made it clear that the uncertainties that prevailed in October were not much clearer at the end of November and suggested that he needed much more definitive evidence to move him off his fence to cut rates.

Then, on Wednesday, Statistics Canada pegged the country's third-quarter real GDP growth at 3.5 per cent – beating the Bank of Canada's October estimate of 3.2 per cent – and upgraded its figures for each of the first two quarters. Mr. Poloz had said in his news conference that the GDP numbers would provide some important insight into the state of the economy.

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The question now is whether the Bank of Canada will use its rate-decision statement to keep alive the possibility of a cut in the first half of 2017 – something the financial markets have all but dismissed. Indeed, the bond market has now priced in a greater chance of a rate increase than a cut by April – which may represent a swing in market sentiment further away from a cut than Mr. Poloz is entirely comfortable with.

Mr. Poloz has no news conference scheduled for this week's rate announcement. The Bank of Canada does those only with every second rate decision, when it also releases its quarterly Monetary Policy Report, and that won't happen again until January. Whatever message the bank may want to deliver, it will have to do so through its rate statement, a brief document outlining the decision that typically runs only a handful of carefully worded paragraphs.

"Having stood pat in October, and seen [economic] data slightly top its projections since then, the Bank wouldn't be able to credibly claim that it seriously considered a rate cut in December," Canadian Imperial Bank of Commerce chief economist Avery Shenfeld said in a research report.

At the same time, though, it may want to strike a tone that keeps markets focused on the unresolved risks ahead – including a new complication, the run-up in bond yields in the wake of Donald Trump's surprise win in the U.S. presidential race. The postelection spike in yields on many government bonds, including Canada's, has increased market interest rates for Canadian borrowers – something that would counteract the stimulative impact of the Bank of Canada's low-rate policy, should it persist, and act as a brake on growth.

By using its rate statement this week to keep alive the possibility of a rate cut, the central bank could dampen market expectations for Canadian interest rates and take some of the heat out of bond yields, leaning against the Trump effect in the market.

"The Bank will simply have to clear its throat and remind the market that a tightening in financial conditions (i.e., higher bond yields) isn't welcome, perhaps just by drawing attention to it," Mr. Shenfeld said. If the bank also emphasizes that the economy is a long way from fill capacity, it serve as a reminder "that there's still an outside chance of a cut, rather than a hike, in the first half of 2017."

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