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As oil falls, questions mount over Bank of Canada rate timing

With the North American benchmark price of oil falling below $60 (U.S.) for the first time in five years, there are growing questions about whether the Bank of Canada will alter its plans on interest rates.

The price of West Texas Intermediate oil dropped 99 cents to $59.95 a barrel on Thursday, the lowest price since July, 2009. The Canadian dollar was pulled down as well, sinking to a five-year low of 86.6 cents.

It's widely assumed that the central bank will begin raising its policy rate from its current 1 per cent in the second half of next year, in response to an accelerating economy, strong U.S. demand for Canadian exports and a gradual rise in inflationary pressures. But Bank of Canada Governor Stephen Poloz last week estimated that oil's slide could shave one-third of a percentage point off economic growth next year. Since he made that estimate, the price of WTI crude has declined another 10 per cent.

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On Thursday, Mr. Poloz maintained a wait-and-see position on how oil might affect the central bank's thinking. In a news conference after a speech in New York, Mr. Poloz indicated that oil's impact on Canada's inflation outlook will be the key factor in determining whether it will alter the central bank's interest-rate timing and direction.

"What we will do, in time for our next Monetary Policy Report in January, is assess how all these things are affecting our projected profile for inflation. That is our anchor for this exercise," he said, in response to a question about oil. "If the risks … are such that the profile for inflation is being pushed down relative to our target, that's when we would be talking about perhaps downside risks to our inflation profile."

While Mr. Poloz didn't specifically comment on what impact he expects oil's tumble would have on Canada's inflation rate, the central bank has previously indicated that a big oil decline, if sustained, would significantly dampen inflation. The bank's general rule, as it outlined in its most recent Monetary Policy Report (MPR) published in October, is that every 10-per-cent drop in the oil price translates into a 0.3-percentage-point decline in the inflation rate over the next year.

In the October MPR, the Bank of Canada projected a consumer price index inflation of 1.8 per cent next year – down from the current rate of 2.4 per cent, which the bank considers to be bolstered by temporary factors, but still approaching the bank's 2-per-cent inflation target that is its primary guide for setting interest-rate policy. But the current WTI oil price is nearly 30 per cent below the $85 level that the central bank built into its assumptions in its 2015 inflation forecast.

However, crude's decline has also fuelled a further retreat in the oil-sensitive Canadian dollar, which has declined nearly 3 cents since October. The lower dollar should boost the cost of imported goods for Canadian consumers, at least partly offsetting the impact on inflation of the falling oil price.

And Thursday's report from Statistics Canada on capacity utilization showed the country's industries operated at an eight-year high of 83.4 per cent of their full capacity in the third quarter of this year. That suggests that the slack in the economy is shrinking – a factor that could also add inflationary pressure in the coming months.

But Mr. Poloz said in his news conference that even though the slack in production capacity may be smaller than previously thought, there is still considerable slack in the labour market. "The excess capacity that the economy is carrying is ultimately a labour-force matter," he said.

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Canada isn't the only country grappling with falling oil prices.

Norway's Norges Bank shocked financial markets on Thursday by cutting its benchmark policy rate by one-quarter of a percentage point, to 1.25 per cent. Norges Bank Governor Oystein Olsen told Bloomberg News that the move was necessary to defend against a "severe downturn in the economy," as the major oil exporter fears crude's 40-per-cent nosedive since the summer will spill over from its big energy sector to the broader economy.

But the Central Bank of the Russian Federation went in the opposite direction, raising the policy rate of the world's second-biggest oil producer a full percentage point, to 10.5 per cent. The bank said the sinking value of the ruble – due in large part to oil's plunge – has become a serious inflation risk; it hopes the rate hike will both support the currency and cool inflation, which it estimates is running at about 10 per cent.

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