Trade threats will likely amplify Poloz’s caution on rates

Bank of Canada Governor Stephen Poloz’s preoccupation with uncertainty probably means a longer pause on interest rates, in a world of fraying trade alliances and volatile markets.

The central banker is expected to leave his benchmark borrowing cost unchanged at 1.25 per cent at a rate decision Wednesday at 10 a.m, according to all 21 economists surveyed by Bloomberg News, with forward contracts pricing in just a 13 per cent chance of a hike.

Investors have been paring back the odds of rate hikes in recent weeks on the back of a run of soft economic data, global market turmoil and growing geopolitical concerns that are expected to heighten Poloz’s already-elevated levels of caution with tightening monetary policy further.

“This one is likely to be a maintenance statement with a more cautious spin that buys time to assess developments,” Derek Holt, an economist with Bank of Nova Scotia, said in a report. “There are some rather compelling reasons to pause the hike cycle.”

These include, according to Holt, uncertainty around trade policy that has worsened with President Donald Trump’s threats to impose tariffs on steel and aluminum, weaker growth numbers, and sluggish investment plans by businesses.

Poloz’s next interest rate increase -- which would be the fourth in the rate-hike cycle -- isn’t being fully priced in until July, swaps trading suggests. A month ago, investors were pricing in at least one increase by May, with a good chance of an April hilke.

Investors are expecting the Federal Reserve to outpace the Bank of Canada on rate hikes over the next 12 months, with at least three hikes in the U.S. over that time versus two for Canada. The rate divergence has been a drag on the Canadian dollar, which has lost 4 per cent since Poloz’s last rate hike on Jan. 17.

ANALYTICAL LENS 

Growing geopolitical concerns could be particularly meaningful to a central banker like Poloz, who has put uncertainty at the forefront of his economic analysis.

That focus was on display last week when Poloz traveled to London to receive an award from Central Banking, a trade publication. In his acceptance speech, he chose to highlight the Bank of Canada’s efforts to be “open and honest” about uncertainty in its policy making.

Poloz’s narrative boils down to something like this:

- There is more uncertainty in the world today.
-This heightened uncertainty is the sort you can’t measure or estimate.
-Geopolitics is an important factor, but so is growing uncertainty about the reliability of models to prescribe policy.
-Because of this, policy makers are injecting more “realism” and judgment into the narrative and nudging the decision-making process toward something that looks less like a mechanical exercise akin to engineering and more like risk management. More art, less science, in Poloz’s words.

This is important since the Bank of Canada’s “mechanical” models are probably telling it to raise interest rates faster than it has, as the country runs up against capacity.

Gradualism is simply the inevitable outcome of a world view that puts a greater emphasis on uncertainty.

“We have been working on the theme of uncertainty since the global financial crisis revealed the limits of our models and our knowledge,” Poloz said in his speech. “And we have learned that it is far better to be open and honest about the uncertainty we face, as well as how we deal with it, rather than to just assume the uncertainty away and project a false sense of confidence.”

TRACK RECORD 

Not everyone is fully bought into Poloz’s focus on risk management. One critique is that the Bank of Canada’s emphasis on uncertainty generates blurry economic analysis, gives officials too much discretion in setting policy and makes it difficult for market players to pin down intentions and form expectations. In other words, it could end up fueling “policy uncertainty” and result in unnecessary volatility.

Poloz himself has acknowledged the economic literature that deals with uncertainty is undeveloped. But that hasn’t necessarily made the governor any more difficult to read.

For example, a cursory analysis of forward contracts suggests investors did a better job predicting Poloz’s policy changes six months forward than had been the case with former Governor Mark Carney’s three hikes in 2010 and a series of rate increases by former Governor David Dodge between 2005 and 2007.

A gradual approach to policy, as a matter of course, means the scope of misreading him is smaller. Slow and steady is always a good bet when it comes to Poloz.