Bank of Canada's Poloz might be spooked by an unnatural economy: Don Pittis

Borrowers and homeowners haunted by thoughts of another hike in interest rates just days before Halloweenmay have been reassured to hear Bank of Canada governor Stephen Polozheld rates steady yesterday.

But those hoping for a simple answer on the trajectory of futureinterest rateshave every reason to remain unnerved.

Only days before the little ghosts and goblins walk the streets, our chief central banker declaredeconomic conditions to be distinctly abnormal.

Uncanny economy

WhilePolozand his deputy, CarolynWilkins,painted a revealing picture of the bank's behind-the-scenes thinking on Canada'seconomic future, their imageshowed they and their advisers remainbaffledby the peculiar persistence of low inflation and static wages in this strengthening economy.

• 'Cautious' Bank of Canada keeps interest rate unchanged

"When you're in a situation that's different from normal which we are you use your models as a guide but you expect deviations in behaviour relative to those models," Poloz said.

"The question is, how much of a deviation?"

Even at the best of times, trying to model the future of an economy that's constantly changing must be a frightening task.

Only the day before Polozspoke, Finance Minister Bill Morneau madechanges of his own that could add tofuture inflation, using his fall fiscal update to increase the low income tax creditand increase child benefits.

Several reporters seemed to be temptingPolozinto a conflictwith Morneauat yesterday's news conference.

Polozrefused to be drawn, stubbornly keeping central bank policy andpolitics apart.

Whileone must accept the idea that central bankers must avoid stepping into politics, monetary and fiscal policy cannot be divorced.

Spooky interaction

The fascinating thing about trying to understand economic and monetary policy is that the whole system is a series of interlocked feedback loops, like an occultRube Goldberg machine, where adjusting one small part changes the entire pattern.

A case in point was the rise of theCanadian dollar, which Wilkinssaid had a significant effect on inflation. But it seems just talking about ithad an effect yesterday.Minutes after the bank released its monetary policy report, the loonie began to plunge, at one point down nearly a full U.S. cent.

But in "different from normal" times, keeping up with such changes isn't the only difficulty for Poloz, Wilkins and their team.

One of those differencesthey described wasthe high level of debt that could makethe entire Canadian economy more sensitive to small changes in interest rates thanit would be under normal conditions.

"When households are more indebted, what happens is that any particular increase in interest rates is going to have a bit more of an impact on the amount of money they have at the end of the day to spend on other things," Wilkins explained.

"The ability of households to borrow more money to get more credit to buy new things is also going to be more constrained," she said. That's significant in an economy where borrowing has become an unusually important part of retail and real estate sales.

Eerie inflation

Another strange thing about the current economic picture is that inflation, not just in Canada but around the world, remains mysteriously low, Poloz said. The bank now expects inflation won't hit its twoper cent target range until the second half of next year, cooling market expectations for immediate interest rate hikes.

The other uncanny factor being pondered by the bank is why wages remainpersistently low. This may be partly due to the chilling effect of a long period of underemployment, whichcould also help hold rates down. As those underemployed or discouraged workers get drawn into the economy bybusinesses seeking to expand, the economy's capacity actually grows.

That's what the governor has characterized as the "sweet spot," where the economy is able to grow without forcing the central bank to raise rates.

If that turns out to be true, that's good news for Canadian borrowers.

But asked directlywhether interest rates, and thus mortgage rates, would go up in December,Polozwas as cagey as ever, hinting a rate rise could be delayed by nine months or come as soon as December.

"The homeowner should acknowledge," he said, "that if the economy continues to do well, as it has been, less monetary stimulus is likely to be needed in the future."

Translation? If the economy remains strong, expect rates to rise.

• ANALYSIS|Canadian interest rates must be just right for a Goldilocks economy

For underemployed people looking for good work, for large and small businesses, and for the sake of Canada's economic future,such continuedstrength would be a treat.

But for the one in three Canadians already feeling the pinch of higher interest rates, it could be a personal nightmare.

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