Walking the tightrope

Bank of Canada Governor Stephen Poloz, in the job for just under six months, has firmly established his credentials as the world's most dovish central banker.  As expected, the Bank has again maintained its reference rate at 1 percent (or "a rock bottom 1 percent", as the media would have it).  However, the tone of its commentary is becoming ever more bleak, and this is starting to trigger some speculation that the Bank might be considering aping the recent unexpected rate cut by the ECB.

What's worrying the Bank is not the absence of growth.  Real GDP growth accelerated to a two-year high of 2.7% (annualized rate) in Q3, and growth forecasts for 2014 are being marked sharply higher, mainly on expectations that continuing expansion in the US will pull the Canadian economy along.  However, the Bank is very worried about the continuing -- and largely unpredicted -- fall in the inflation rate, which slipped to only 0.7% in October, far below the official 2% target.  Did I say Target?? The Bank appears to believe that the arrival of US discount chains, including Target, in the Canadian marketplace is leading to heightened price competition and keeping the measured inflation rate subdued.  Most Canadians would say that's a good thing (and ironically, Target is reportedly falling way short of its sales projections), but for the Bank it's apparently a real cause for concern.

What happens next?  As the linked article notes, some Bay Street experts think that the Bank is trying to achieve monetary easing without actually cutting rates, by talking the dollar down.  If that's the plan, it seems to be working.  The currency's months-long slide from above parity with the US dollar is gathering pace; it's now near the 93-cent level, and plenty of experts see it falling below 90-cents in early 2014.  A weaker dollar helps the Bank out in many ways.  It gives a boost to the beleaguered manufacturing sector, which has been hollowed out by the currency's strength in recent years.  It adds directly to the cost of imported goods, and by making cross-border shopping less attractive, it gives local retailers more room to boost prices.  As these effects play out, the weakness in inflation is likely to reverse quite sharply in the months ahead.

The interesting question, of course, is this: if the Bank is really so concerned about the risks of deflation, why doesn't it just bite the bullet and cut rates?  The answer to this lies in the state of the housing market and the growth of consumer indebtedness.  The Bank persists in denying that there are any signs of a bubble in the housing market, but all the evidence suggests that the cheap-money-fueled boom in the condo market is leading to serious oversupply in the country's biggest cities.  At the same time, consumer debt is stubbornly high, with the debt/disposable income ratio close to the levels that led to disaster in the US half a decade ago.

A weak dollar may be just what Gov. Poloz needs in the short term.  At some point, however, the Bank will have no choice but to start thinking about raising rates.  When that happens, a lot of consumers (and a lot of condo owners who have bought properties as an investment) will start to feel pain very quickly.