From mortgages to NAFTA, the Bank of Canada shows it has real political clout: Don Pittis

Bank of Canada governor Stephen Poloz always insists he doesn't play politics. He also insists the bank is not concerned with the value of the Canadian dollar.

But that may not behow the world sees it.

Markets now seem confident that Polozwill increase interest rates by a quarter of a percentage point on Wednesdaywhen he presents the bank'slatest Monetary Policy Report.

Canadians already know Poloz has power over their borrowing costs. The expectedhike in rates will be another blow to many heavily mortgaged Canadians, who will once again have to look for extra cash to top up their monthly payments.

• Canadian banks hike mortgage rates

But last Wednesdayit seemed a Bank of Canada rate hike was far from a sure thing.

NAFTAor bust

The past week offered a fascinating insight intothepower of Canada's central bank to respond to a political event.

The event in question was areport from the news agency Reutersquoting unnamedCanadian government sources that U.S. President Donald Trump was pulling the plug on the North American Free Trade Agreement..

Described by one commentatoras"a moment of high drama," CBCNews confirmed the Canadian government was preparing for a collapse of the struggling trade deal.

In the bizarre world of Trump's outrageous statements and retractions, it's hard to be sure where the rumour started.

Buta subsequent interview with Trump in the Wall Street Journalshowed him backing away from any anti-trade sentiments with comments that included, "We've made a lot of headway."

From gloom to mere uncertainty

It was that abruptone-day change fromNAFTAgloom to regular old NAFTAuncertainty that offered hints that Polozhas room tomanoeuvre. Or at least that is what market players believe.

Exactly how damaging a NAFTA pullout would be for the Canadian economy remains in dispute. But evidently the people who trade in Canadian dollars are worried about its impact.

Surveys by the business wire services show the most influential bank economists are confident a rate rise is coming this week. One of the reasons for that confidence is that they examine other market indicators, including the Canadian dollar swaps market.

Those swaps, a composite ofcurrency traders betting on where the Canadian dollar will go next, are surprisingly accurate predictors of what Poloz will do,possibly because traders mimic the considerations the Bank of Canada uses in making its decision.

And a look at those bets overa week was instructive. Astronger-than-expectedCanadian jobs report on the previous Friday sent market expectations of a January rate rise which had been closer to 50 per cent before Christmasup tonearly 90 per cent. The loonie climbed, too.

But following Wednesday's reports and rumours ofNAFTA'ssudden death, those market expectations plunged to just above 60 per cent, and with themthe Canadian dollar.

Loonie's trade impact

When Trump suddenly appeared to put the brakes on those rumours, expectations of a Poloz increase in rates jumped once again, and so did the loonie.

Whatthe market reaction to Trump's comments shows is thattraders believePolozwould be willing to adjust interest rates to cope with a sudden collapse in NAFTA. And that change in the trajectory of rates would have a real political impact.

With two quarter-point rate cuts in 2015 following the crash in the price of oil, the Bank of Canada showed it was not shy about usinginterest rates to repair damage to the Canadian dollar caused by forcesoutside Canada.

And while at the timePolozand the bank put that in the context of Canada's inflation rate and the economy'scapacity, Canada's trade partners saw it differently. To them is was an adjustmentto the trade relationshipas a falling loonie made Canadian imports more expensive and Canadian exportscheaper.

The reaction to Trump's purportedNAFTAultimatum showed the markets believedPolozcould make a similar move if the U.S. suddenly pulled out of the trade deal.

Politically, that makes killingNAFTAless appealing to U.S. businesses. By weakening the economy of their biggest tradingpartner,a falling loonie would force Canadians to buy less while Canadian exports became more competitive in world markets.

Of course, whenPolozspeaks on Wednesday, the potential loss ofNAFTAwill be only one of several considerations he will have to address.

Inflation rising, but Canada to 'wane'

Surprisingly high core inflation numbers in the U.S. on Friday seemto showthe U.S. Fed willlead the Bank of Canada into furtherrate increases laterthis year.

• U.S. inflation jumps, boosting likelihood of rate hike

Canada will get its own reading on inflation at the end of this month. But so far this country's core inflation remains below two per cent, which gives Polozsome flexibility.

In other ways, the long-term outlook remains uncertain. Risingminimum wages in Ontario and other provinces could increase inflation. But there are signals things could be heading in the other direction, especially if higher wages help take the economy off the boil.

The high level of Canadian indebtedness could mean rising rates will hit the economy much harder than its competitors, hurting real estate andthe strong construction industry it supports. Meanwhile, an internal memo to Finance Minister Bill Morneau warns that the Canadian economy is about to "wane."

With luck Polozand his deputyCarolynWilkins will make sense of it all for us on Wednesday.

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