Wilkins Lays Out Reasons for Bank of Canada's Sudden Caution

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(Bloomberg) -- It’s going to be a delicate balancing act.

That’s the message Bank of Canada Senior Deputy Governor Carolyn Wilkins took to New York Wednesday in a Bloomberg Television interview and speech, where she highlighted the challenges the central bank is facing as it tries to fine tune policy to take account of faster growth without damaging the recovery.

Her speech on “Embracing Uncertainty in the Conduct of Monetary Policy” gave the central bank’s most detailed explanation yet about why policy makers recently turned cautious about the interest rate outlook, saying one reason is the desire to avoid a potentially costly policy reversal. At the same time, caution has its limits, Wilkins said.

“Whether it’s about how aggressive or how cautious policy should be -- getting the dosage right demands sound judgement about complex trade-offs,” she said in the speech. “Uncertainty is not a reason for paralysis in decision making.”

Like central banks elsewhere, the Bank of Canada is trying to figure out how to bring extraordinary monetary stimulus and historically low interest rates to more normal levels, without inadvertently triggering another downturn. Investors anticipate two more hikes by the end of 2018, swaps trading suggests, after the bank raised rates twice this year.

Eye on Growth

One argument against rate increases is persistently weak inflation, which in theory suggests rates should remain low. But Bank of Canada officials have warned against reading too much into the sluggish readings, saying they’ll rely heavily on a variety of incoming data to determine their next step.

In her interview with Bloomberg, Wilkins said the Bank of Canada is keeping a close eye on growth as a key gauge of price pressures, instead of noisy inflation readings, as it considers when to raise interest rates again.

“Growth on the other hand, you can look at very carefully as an indication of where the economy might be going in the future, where those wage pressures could be, how the labor market is going to perform, and that is what is going to be a longer-term driver of inflation pressures in the future,” Wilkins said, adding about 75 percent of the variability in total inflation is due to consumer energy prices.

The comments suggest policy makers may be inclined to look past the current weak inflation data if the nation’s economy continues to grow at rates that drive it up against capacity.

“In October we were clear that we think over time that less monetary stimulus is likely to be appropriate, and at the same time we were going to be cautious about it,” she said in the interview.

The relationship between economic slack and inflation however hasn’t broken down, she said. “We don’t see that that relationship has gone away completely,” she said.

While there is little sign of strong inflation pressure at the moment, the central bank forecasts a return to its 2 percent target in the second half of 2018.

“As we look forward and we see that slack in the Canadian economy is being absorbed, well then that source of drag on inflation is going to go away,” Wilkins said.

Less Stimulus

Wilkins justified the two rate increases by saying Canada’s economy was “progressing quite strongly” earlier this year. Caution is now warranted as policy makers monitor inflation and the sensitivity of the economy to higher interest rates, Wilkins said.

It’s a theme she emphasized in her New York speech. The central bank puts a greater weight on the downside risks when inflation is already low, the senior deputy said, adding it’s unclear just how much the increased sensitivity of indebted consumers to higher interest rates will affect spending.

Another reason for caution is the desire to avoid a policy reversal, Wilkins said.

“During periods of uncertainty like today, a cautious approach may be prudent,” Wilkins said.

For businesses, Wilkins said the risks around negotiations to renew or scrap the North American Free Trade agreement are weighing on new investments. “Canadian businesses are telling us that when they’re thinking about investment they have to be more cautious than otherwise,” she said in the interview. The fifth round of Nafta talks begin in Mexico City this week.

©2017 Bloomberg L.P.

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