Handing over Her Majesty's Canadian Ship Bank of Canada, Mark Carney, looking smart in his dress whites, flashes his trademark broad smile. His crisp salute transforms effortlessly into a charming wave to cheering crowds as he sails away to his next, more prestigious command aboard the HMS Bank of England.
Meanwhile on the bridge of the Bank of Canada, in Newfoundland-style slicker and Sou'wester hat, a worried-looking Stephen Poloz takes over the helm and squints into the fog bank ahead.
Poloz is right to be nervous as he begins his seven-year term Monday as the new chief of Canada's central bank.
In central banking as in many other fields, the past is an open book. The future is always obscure. But this profession has an added danger: an economy threatening to improve can be bad for a central banker’s popularity.
Carney departs a shining hero. As governor of the Bank of Canada during the storms of the Great Recession, he steered a safe course, judiciously letting rates fall from 3.5 per cent to almost zero at the depths of the crisis, then keeping them low as the economy showed weak signs of recovery.
As the new governor, Poloz has none of the glory and a far more difficult task. The reason is the difference between cutting interest rates and raising them.
Making the cut
Cutting rates makes you everyone's friend. It makes money cheap. It makes stock markets rise. It makes it easy to get a mortgage and keeps mortgage rates low. Low rates mean lower payments, which puts money in your pocket.
Low rates make the price of your house rise as everyone piles into the market. They make people want to buy houses, stimulating the construction and real estate industries. Low rates stimulate exports by keeping your currency cheaper than it would otherwise be.
But that doesn't mean low rates can go on forever.
"We are building in pervasive problems for the economy," says C.D.Howe fellow Paul Masson in a recent report titled The Dangers of an Extended Period of Low Interest Rates. http://www.cdhowe.org/pdf/Commentary_381.pdf
The report advises the Bank of Canada to start raising rates immediately.
What it says is hardly radical. Few economists would disagree that keeping rates too low too long causes distortions and stores up trouble for the future.
"Below-equilibrium interest rates for an extended period distort investment decisions, leading to excessive risk taking and inefficient, and ultimately unprofitable, investments," says Masson. "They also encourage the formation of asset bubbles whose collapse could lead to a recurrence of the recent financial crisis."
The principle that interest rates must rise eventually may not be in dispute. But that does not mean it will be painless. The reason for the pain is that raising interest rates does the opposite of all those nice things mentioned above.
It makes money more expensive. It makes stock markets fall, at least in the short term. It makes it harder to get a mortgage and pushes mortgage rates up. Higher rates mean higher payments, which takes money out of your pocket.
High rates make the price of your house fall as buyers shun the market. They make people who can no longer afford their payments want to sell, increasing the supply on the market and discouraging construction. Higher rates tend to push the currency up, making it harder to export.
A few people benefit, including older investors who prefer the safety of interest income to the riskier stock market. But in the medium term the effect of raising rates is a downer on the economy.
As the longest-serving chairman of the U.S. central bank, William McChesney Martin, once said, the worst part of the job is that you have to "take away the punch bowl just as the party gets going."
And if that wasn’t enough, Stephen Poloz has something worse to worry about. Moving too soon. Or too late.
The effect of raising or lowering interest rates is far from instant, taking between six months and a year to kick in. Raising rates too soon could lead to a new recession.
Waiting too long could lead to runaway inflation of the kind we faced in the 1970s and 80s, when the Bank pushed rates up into the high teens to get ahead of 13 per cent inflation. Mortgage rates climbed above 20 per cent.
So far the signals are conflicting. Last Wednesday, one set of figures showed wages increasing at more than three per cent, well above the inflation target. On Friday, other data showed the Canadian economy outpacing that of the U.S. But the same week, the OECD predicted the Canadian economy would slump.
Knowing what the economy will do in six months or a year is a very difficult task. That’s why the new governor must squint into the fog bank and worry. But one way or another, eventually, Poloz has to be a party pooper. That’s his job.