Central bank interest rate decisions don't get much more suspenseful than this.
The Bank of Canada will issue its latest policy announcement Wednesday morning (10 a.m. ET), in a true nail-biter of a decision as the country's struggling economy has been hit by a new wave of slumping oil prices to start the year. The market has see-sawed over the past week on whether the central bank will cut its key interest rate for the third time in a year, but as of late Tuesday, bond traders were split almost right down the middle, pricing in a 54-per-cent chance of a cut. It's too close to call.
Consider these possible scenarios that could play out in the Bank of Canada's decision:
1. No cut.
If the bank decides to hold steady on its key rate, it could lend meaningful support to the Canadian dollar, which has slumped over the past week in no small part because of growing expectations of a cut. But it will have to do some fast talking to justify a stand-pat decision, lest Mr. Poloz and his friends be branded as near-delusional in their optimism.
There's no question that the economic outlook has deteriorated. Any reasonable revisions to the growth forecasts should put them at a level where the country won't eat into its output gap at all this year – a gap that the central bank is committed to closing. An unrealistically Pollyanna-ish assessment of the economy could compromise confidence that the country's monetary policy makers are on top of the situation, which would undermine any benefits from the bank's apparent vote of confidence.
The bank could stress its very legitimate need to see how several existing stimulative factors play out before determining whether the economy needs an additional cut. Last year's cuts are still months away from transmitting their full effect on the economy; the same is true for the benefits to exports from the latest declines in the currency. It's uncertain how much of the latest downdraft in oil will be sustained. And the bank knows there's an infrastructure-spending commitment coming from Ottawa that will help offset the recent economic negatives, but it hasn't been incorporating those effects into its economic calculations yet, since the government hasn't formally announced its plan. So there are a few reasons to think the economic outlook has some meaningful upside risk from where it stands right now, which needn't get lost in the bleak snapshot of the current situation.
If the bank makes clear that it is waiting for better visibility, but is leaning toward a cut if it doesn't like what it sees when that smoke clears, then it might be able to buy itself a little time for markets to stabilize and the potential positives to take hold – with a more stable currency beneath the country's feet in the meantime.
If the bank decides to cut, the bottom line will be that the economy isn't growing fast enough to close the output gap over the bank's six-to-eight-quarter policy horizon – which was the bottom line in last year's rate cuts, too. The danger is that a cut, justified by a suitably grim economic outlook, could convince the markets that there is more monetary easing to come – a sentiment that could be another body blow to the already reeling currency.
But if the central bank adopts the tone that this cut is really about buying insurance against further downside risks to growth – similar to the bank's message when it cut rates a year ago – while stressing the upside potential from the weaker dollar, solid U.S. demand and the coming government infrastructure spend – it could convince investors that this rate cut will be the last.
This might be a way for the central bank to have its cake and eat it, too. The bank could cut, while making an explicit statement that it intends to hold its rate at the new level either for a minimum period of time or provided the economy meets minimum targets (most likely tied to inflation, as the bank relies on its 2-per-cent inflation target as the critical guide to setting rate policy). This is a policy tool that central bankers call "forward guidance," an innovation introduced by then-Bank of Canada Governor Mark Carney in the 2008-2009 global financial crisis to influence market interest rates without resorting to a rate cut.
Respected Canadian economist Ted Carmichael proposed this guidance options in a recent blog post, arguing that it would put an entirely necessary cut in place, while snuffing out a potentially disruptive stampede out of the Canadian dollar. But it would require a serious mental shift for Mr. Poloz, who formally dropped the Bank of Canada's use of forward guidance in the fall of 2014, arguing that it distorts markets and should be used sparingly.
Mr. Poloz has maintained that guidance should generally be reserved for when interest rates are at their effective bottom; given that the bank recently published research suggesting that it would be possible to take its key rate as much as half a percentage point into negative territory before hitting its effective bottom, it would appear that Mr. Poloz still has room to cut further before meeting his preferred conditions for forward guidance. There's nothing stopping him from revising this rule of thumb, but it would surely raise some eyebrows if he did.