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opinion

Michael R. King is an Associate finance professor in the Ivey Business School at the University of Western Ontario.

The word "oil" appears 205 times in the Bank of Canada's January Monetary Policy Report and 132 times in April's report. By comparison, variations on the word "inflation" appear just 64 and 67 times, respectively.

These figures highlight the crucial role the price of oil plays for Canada's current economic outlook and the future path of monetary policy. But the dilemma for Bank of Canada Governor Stephen Poloz is that this price is entirely outside the bank's control. This plagues Canadian households, as oil prices may affect the timing of future interest rate increases. So how does oil affect the bank's monetary policy? How does the bank deal with this source of uncertainty in its forecasts? And what should outsiders be watching to get a better idea of the path for Canadian interest rates?

In the economist's terminology, the price of oil is a stochastic (random) variable that creates shocks for the Canadian economy. By random, I mean there may be a pattern, but it cannot be predicted precisely based on past movements. The oil price is set by global forces that include global demand and supply. But oil is also affected by geopolitics. Even the Organization of Petroleum Exporting Countries cannot control the oil price, although they control a larger part of crude oil reserves.

How important is oil for Canada's monetary policy? The short answer is "very." Oil and gas extraction accounts for 6 per cent to 7 per cent of Canada's gross domestic product and crude oil makes up 14 per cent of exports. But research shows that oil prices are volatile and forecasts imprecise. The Bank of Canada does not attempt to forecast prices, but assumes they will remain near recent levels. The January Monetary Policy Report, for example, reported that the bank expected crude oil prices for Brent, West Texas intermediate and Western Canada Select to average roughly $60, $55 and $40 (U.S.), respectively. These values were used when constructing the bank's economic forecast when it cut the overnight rate target on Jan. 21.

By April's report, average crude oil prices were $5 lower. This change was important. The January report explained that a drop in the oil price of $10 a barrel would lower expected real GDP growth by 0.25 percentage points, from 1.50 to 1.25 per cent. A drop in oil prices would also widen the output gap, leading to more spare capacity in the Canadian economy and fewer inflationary pressures. The implication is that lower oil prices would slow the economy. With crude oil prices now about $10 higher than in April, presumably the negative impact on GDP growth has reversed.

The bank has three strategies for dealing with a stochastic variable such as the oil price: research, monitoring and communication.

It goes to great lengths to research how the Canadian economy is affected by oil. A quick search of its website shows the bank has published 28 research articles on oil since 1995, 23 of them since 2007. This research finds that the relationship among oil, the economy and inflation changed dramatically over the past 20 years as Canada became a large oil exporter. It shows that there is no accurate way to forecast prices. It highlights the growing correlation between oil and the Canadian dollar. And it models how oil prices affect U.S. economic growth and, by default, Canada's net exports. The bank has incorporated these findings into its projection models to forecast how inflation will evolve.

The second strategy is monitoring. The bank is speaking to oil producers and other businesses around Canada, liaising with central banks around the world and following price developments closely. In Canada, there is probably no one outside Alberta's oil patch who is paying closer attention to oil prices. This intelligence is factored into the bank's economic forecasts.

The third strategy is communication, by way of speeches, the Monetary Policy Report and testimony to Parliament. The bank uses specific language in the report to describe variables it cannot control or predict with any precision. They are referred to as "risks" to the projection, with the risks characterized as either downside (bad) or upside (good). The importance of a risk at any moment is signalled by its ranking in the report. In January, oil prices were considered the second-biggest risk after U.S. private demand. In April, the No. 1 risk was "greater impact of the decline in oil prices." Oil has featured prominently in Mr. Poloz's recent speeches and public appearances. By explaining how the bank views oil and factors it into its inflation forecast, Mr. Poloz is signalling to households and businesses what will happen to interest rates.

The price of oil is an important variable for Canada's economic forecast and future interest rates, but one of many. To predict what will happen to the policy rate over the coming year, you need to take a view on oil. If prices recover, the output gap will close more quickly and rates will rise sooner. But if prices remain depressed, it could be some time until rates climb.

These forecasts are ceteris paribus – "other things held constant."

But other things never stay the same. So good luck, Mr. Poloz.