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The Facts Have Changed, But the BOC May Not Change Its Mind

Don Curren December 4, 2018

The Bank of Canada may be about to have its John Maynard Keynes moment.

Challenged about his tendency to change his mind rather frequently, the great British economist reportedly said “When the facts change, I change my mind. What do you do, sir?”

The factual change that’s confronting the Bank of Canada is the rapid drop in crude oil prices of the last several weeks. The change of mind it will have to make by Wednesday is whether to stop raising interest rates or stick to the course of gradual tightening it embarked on last July.

The Bank is expected to leave its overnight target rate steady at 1.75% at its last policy announcement of the year on Wednesday, but it can use its policy statement to signal whether it’s sticking to its tightening trajectory or retreating from it.

It also gives the Bank a vehicle to communicate how it views the complex issues surrounding oil prices and the Canadian economy – and perhaps offer an assessment of how the production cuts announced Sunday by the province of Alberta will affect the GDP growth.

Canada’s economy is heavily exposed to the vagaries of global oil prices. The energy sector accounts for about 10% of Canada’s GDP, and about 20% of its exports (the former as of August and the latter as of September, according to Statistics Canada). Its influence on the economy is arguably greater, though, than those numbers suggest.

The volatility of oil prices breeds volatility in the sector. Whereas other sectors tend to chug along at the same speed and make a reasonably steady contribution to the country’s economy, the energy sector is more variable. Its ups and downs often go a long way toward determining the overall level of growth.

The impact of tumbling oil prices on Canada’s economy is exacerbated by the fact that prices for some Canadian oil, as reflected in the Western Canadian Select benchmark, have been hit particularly hard by this fall’s collapse in oil prices.

As prices continued to explore new lows, the calls on the Bank of Canada to abandon its hawkish tilt have risen steadily in volume.

On Sunday, news that Alberta’s government has ordered oil producers to cut production by 8.7%, or 325,000 bpd, as of January prompted a relief rally in prices for Western Canadian Select (WCS), which had gained roughly 10% by afternoon trading Monday.

(The cuts are expected to be rolled back to about 1/3rd of the size by the spring.)

That reduces some of the pressure for a response from the Bank on the issue of lower prices for Canadian oil. But Alberta’s cuts will likely slow GDP growth noticeably, and may force the Bank to reassess its growth forecast.

What seems to be particularly galling for some advocates of a dovish turn is the Bank’s apparent lack of concern for the plunge in oil prices.

Neither Governor Stephen Poloz nor Senior Deputy Governor Carolyn Wilkins mentioned the threat posed by lower oil prices in recent speeches.

Wilkins did address the subject in an interview with Montreal’s French-language newspaper La Presse, where she characterized the impact of lower WCS prices as relatively limited.

Wilkins said the roughly 90% of Canadian oil that’s transported by pipeline is not subject to WCS prices, leaving only 10% that nets the lower prices.

While the decline is consequential for companies that are exposed to WCS pricing, it is not as important for the economy as a whole as it has been in the past, she said.

In 2014-2015, investments in the energy sector accounted for 30% of total business investment, and at this point it is about 19%, Wilkins said.

She said that business investment in the energy sector will go down, but a resumption of investments in this sector is not part of the Bank’s forecasts.

The economic consulting firm Capital Economics has cited the current low level of business investment in energy as one of three key reasons the slump in oil prices won’t knock the Bank of Canada off its path toward higher rates.

The second is the increased efficiency of the oil industry – Capital Economics says breakeven operating costs are reportedly around 50% lower now than in 2015.

The third is the fact, also cited by Wilkins, that most Canadian oil fetches a higher price than that indicated by the WCS benchmark.

While these arguments suggest GDP growth in Canada may be less vulnerable to lower oil prices than it was in 2014-15, that will be cold comfort to the citizens of Alberta and other oil-producing regions. The oil price slump comes at a time when major pipeline construction is stymied, and the combination of those factors has fostered a rise in regional alienation that hasn’t been evident in the last few years.

BMO Capital Markets said in a report Monday that Alberta’s production cut will affect the Bank of Canada’s growth forecast, “but the drop in production is expected to be temporary and therefore shouldn’t have a big impact on policy.”

It may be hard for Poloz to relinquish the push for rate normalization. Certainly, all the rhetoric emanating from the Bank in the last few weeks suggests a hawkish stance on rates is well entrenched there.

The Bank believes the neutral rate setting for Canada is between 2.5% and 3.5%. Just a few more hikes would bring the overnight target rate to that neighborhood, which Poloz considers an integral part of bringing the economy “home,” as he puts it.

But “home” is proving to be a bit like the Emerald City in the Wizard of Oz. It looks tantalizingly close, but then something unexpected keeps it out of reach – a field of poppies for Dorothy and her friends, and cratering oil prices for Poloz and his.

Footnote: If you believe it’s a fact that Keynes said “When the facts change, I change my mind. What do you do, sir?”   you may have to change your mind. According to at least one source, the observation was first made by the American economist Paul Samuelson, and then later attributed by him to Keynes.

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Watch a discussion between Don and Karl about monetary policy at the Bank of Canada: Don & Karl: The Series – Bank of Canada | The Facts Have Changed, But…

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