'We have less spending power today than we had before because oil prices are lower, even though you and I aren't oil exporters,' said Bank of Canada governor Stephen Poloz yesterday.

It's even worse if you are an oil exporter.

The price of oil, which continued to plunge even as Poloz was speaking, was at the heart of the Bank of Canada's decision not to cut interest rates, even though many expected a cut.

Also for the first time, Poloz made it clear that the Bank of Canada was prepared to defend the loonie against against rapid declines. The reason was fear of oil-related inflation.

Usually the central bank governor responds to questions about the loonie by saying its value is not part of the bank's remit. Besides general economic health, the governor's only concern is the level of inflation, using interest rates to keep average price rises close to its two per cent target.

Dangerously entangled

But as oil and the Canadian dollar continue their tandem descent, suddenly the bank is concerned that the loonie and inflation have become dangerously entangled.

Fruit Veggies Loonie 20160112

So far, inflation figures show that the rising cost of imported food are being balanced by the falling prices of other things. But Poloz says he would act to avoid raising inflation expectations caused by a falling loonie. (Paul Chiasson/Canadian Press)

"When [the dollar's decline] happens very quickly, we know it passes through into imported prices and that affects how we measure inflation," said Poloz. "People see it all at once, and when that happens it's possible that process could begin to influence their expectations of inflation."

We might not realize it, but due to 25 years of discipline by our central bank, Canadians have become convinced that prices do rise, but at a steady annual rate of about two per cent or less. When we somehow sense they have begun rising too fast, we begin to push for salary increases (or price rises if we are a retailer or service provider) to keep pace.

Poloz made it quite clear he would be willing to boost rates it necessary to protect that 25-year low-inflation legacy.

The latest inflation figures are coming out on Friday, but in the most recent data average price increases, while rising, remained well below target at 1.4 per cent. But stories about the doubling price of cauliflower and $3 cucumbers may be giving people a magnified view of inflation.

Fully stimulated

The other reason Poloz and the bank's governing council determined not to cut rates is that the economy is already being fully stimulated by low oil prices and the export advantages of a lower loonie, which will kick in only gradually. 

"The Canadian dollar has declined significantly since October," Poloz said in his introductory remarks, "which means the non-resource sectors of our economy are receiving considerably more stimulus than we projected then."

That's why despite all the gloomy news, Poloz remains relatively upbeat about the Canadian economy. While less optimistic about global growth than recent IMF forecasts, the Bank of Canada expects Canada to grow at about two per cent during this calendar year.

Not added into the bank's calculations was the effect of fiscal stimulus promised by the Liberal government, which could boost inflation, but also make future bank outlooks even more optimistic.

That provides little solace to Canada's oil producers. Poloz admits an adjustment process now underway means they will continue to suffer as non-resource parts of the economy grow.

CANADA-NORWAY/OILSANDS

A cup holds heavy oil extracted from the oilsands. Poloz says some Canadian oil is cheap to produce, but higher-cost producers will be affected the most by falling prices. (Reuters)

"That adjustment process sounds mechanical," he said sympathetically, "In fact, it's personal."

Poloz expects the resource sector to continue shrinking as producers hit the price threshold below which it is no longer worth extracting oil.

"The lower the price goes, the more you concern yourself with the question, 'What is that threshold?' Some of our oil is quite inexpensive to produce," said Poloz. "But some of our other oil is much more expensive to produce."

In fact, the multiple extraction and upgrading processes for oilsands bitumen make it some of the most expensive oil in the world to produce. If the global battle to see who blinks first is based on cost of production, further declines in oil prices are likely to hit us eventually.

Oilsands producer Nexen has shut down operations at its Long Lake project after an accident, and there is speculation that low prices mean it will not be worth resuming production.

Calgary-based Connacher has cut output from its Great Divide oilsands project from 14,000 barrels a day to 3,000, but according to Report on Business journalist Jeff Lewis, larger producers can keep losing money for now. That could change if prices drop below $20, he writes.

If that happens, expect to see even more of a two-track economy. But if continued declines in the price of oil cause inflation expectations to rise as the loonie tumbles rapidly, don't expect more interest rate cuts. 

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