Analysis

From mortgages to NAFTA, the Bank of Canada shows it has real political clout: Don Pittis

Last week's rumours that U.S. President Donald Trump was axing NAFTA showed just how much power the Bank of Canada wields.

Loonie's plunge after Trump trade threat is evidence, as Poloz responds to political events

Interest rates are going this way according to all market indicators, but Bank of Canada governor Stephen Poloz has room to manoeuvre. (Chris Wattie/Reuters)

Bank of Canada governor Stephen Poloz always insists he doesn't play politics. He also insists the bank is not concerned with the value of the Canadian dollar.

But that may not be how the world sees it.

Markets now seem confident that Poloz will increase interest rates by a quarter of a percentage point on Wednesday when he presents the bank's latest Monetary Policy Report.

Canadians already know Poloz has power over their borrowing costs. The expected hike in rates will be another blow to many heavily mortgaged Canadians, who will once again have to look for extra cash to top up their monthly payments.

But last Wednesday it seemed a Bank of Canada rate hike was far from a sure thing.

NAFTA or bust 

The past week offered a fascinating insight into the power of Canada's central bank to respond to a political event.

The event in question was a report from the news agency Reuters quoting unnamed Canadian government sources that U.S. President Donald Trump was pulling the plug on the North American Free Trade Agreement..

Described by one commentator as "a moment of high drama," CBC News confirmed the Canadian government was preparing for a collapse of the struggling trade deal.
Despite the apparent bonhomie between Prime Minister Justin Trudeau and U.S. President Donald Trump, the president's views on NAFTA remain unclear. (Jonathan Ernst/Reuters)

In the bizarre world of Trump's outrageous statements and retractions, it's hard to be sure where the rumour started.

But a subsequent interview with Trump in the Wall Street Journal showed him backing away from any anti-trade sentiments with comments that included, "We've made a lot of headway." 

From gloom to mere uncertainty

It was that abrupt one-day change from NAFTA gloom to regular old NAFTA uncertainty that offered hints that Poloz has room to manoeuvre. Or at least that is what market players believe.

Exactly how damaging a NAFTA pullout would be for the Canadian economy remains in dispute. But evidently the people who trade in Canadian dollars are worried about its impact.

Surveys by the business wire services show the most influential bank economists are confident a rate rise is coming this week. One of the reasons for that confidence is that they examine other market indicators, including the Canadian dollar swaps market.
While putting up trade barriers to Canadian goods may help U.S. producers in the short run, it might force Canada to cut interest rates and drive the loonie lower. That would make Canada's exports more competitive. (Jonathan Hayward/Canadian Press)

Those swaps, a composite of currency traders betting on where the Canadian dollar will go next, are surprisingly accurate predictors of what Poloz will do, possibly because traders mimic the considerations the Bank of Canada uses in making its decision.

And a look at those bets over a week was instructive. A stronger-than-expected Canadian jobs report on the previous Friday sent market expectations of a January rate rise — which had been closer to 50 per cent before Christmas — up to nearly 90 per cent. The loonie climbed, too. 

But following Wednesday's reports and rumours of NAFTA's sudden death, those market expectations plunged to just above 60 per cent, and with them the Canadian dollar.

Loonie's trade impact

When Trump suddenly appeared to put the brakes on those rumours, expectations of a Poloz increase in rates jumped once again, and so did the loonie.

What the market reaction to Trump's comments shows is that traders believe Poloz would be willing to adjust interest rates to cope with a sudden collapse in NAFTA. And that change in the trajectory of rates would have a real political impact.

With two quarter-point rate cuts in 2015 following the crash in the price of oil, the Bank of Canada showed it was not shy about using interest rates to repair damage to the Canadian dollar caused by forces outside Canada.

And while at the time Poloz and the bank put that in the context of Canada's inflation rate and the economy's capacity, Canada's trade partners saw it differently. To them is was an adjustment to the trade relationship as a falling loonie made Canadian imports more expensive and Canadian exports cheaper.
Poloz must decide if rising Canadian minimum wages will help or hurt the wider economy, and increase or decrease job openings. (Don Pittis/CBC)

The reaction to Trump's purported NAFTA ultimatum showed the markets believed Poloz could make a similar move if the U.S. suddenly pulled out of the trade deal.

Politically, that makes killing NAFTA less appealing to U.S. businesses. By weakening the economy of their biggest trading partner, a falling loonie would force Canadians to buy less while Canadian exports became more competitive in world markets.

Of course, when Poloz speaks on Wednesday, the potential loss of NAFTA will be only one of several considerations he will have to address.

Inflation rising, but Canada to 'wane'

Surprisingly high core inflation numbers in the U.S. on Friday seem to show the U.S. Fed will lead the Bank of Canada into further rate increases later this year.

Canada will get its own reading on inflation at the end of this month. But so far this country's core inflation remains below two per cent, which gives Poloz some flexibility. 

In other ways, the long-term outlook remains uncertain. Rising minimum wages in Ontario and other provinces could increase inflation. But there are signals things could be heading in the other direction, especially if higher wages help take the economy off the boil.

The high level of Canadian indebtedness could mean rising rates will hit the economy much harder than its competitors, hurting real estate and the strong construction industry it supports. Meanwhile, an internal memo to Finance Minister Bill Morneau warns that the Canadian economy is about to "wane."

With luck Poloz and his deputy Carolyn Wilkins will make sense of it all for us on Wednesday.

Follow Don on Twitter @don_pittis

More analysis from Don Pittis

About the Author

Don Pittis

Business columnist

Don Pittis was a forest firefighter, and a ranger in Canada's High Arctic islands. After moving into journalism, he was principal business reporter for Radio Television Hong Kong before the handover to China. He has produced and reported for the CBC in Saskatchewan and Toronto and the BBC in London. He is currently senior producer at CBC's business unit.

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