The Bank of Canada vs. the Government of Canada

In an interview earlier this month, Canada’s Finance Minister Jim Flaherty suggested that the Bank of Canada (BoC) could feel pressure to raise short-term rates later this year if the US Federal Reserve continues to taper its extraordinary stimulus. Mr. Flaherty also cited reports from the International Monetary Fund (IMF) and the Organisation for Economic Co-operation and Development (OECD) that argued that the central bank should hike rates.

Of particular concern to Mr. Poloz, Governor of the Bank of Canada however is the fact that inflation, as measured by the consumer price index (CPI), has been below the bank’s 2 percent target for 19 consecutive months. In the two most recent readings, in fact, the CPI actually came in below 1 percent. That suggests that even after several years of highly accommodative monetary policy, the threat of deflation has yet to be fully extinguished.

While central banks are usually able to rein in inflation quite effectively, a deflationary spiral can quickly get out of control. To forestall that possibility, the BoC’s currently dovish stance on rates does not rule out another rate cut should the economy weaken further.

But even here, Mr. Poloz is in a tricky situation. Canadian consumers are overleveraged and the housing market is overvalued, so a rate cut could contribute toward expanding the bubble in housing. Meanwhile, a rate hike would hit those same debt-burdened consumers hard, while also possibly undermining business investment, which remains tepid.

Despite Mr. Flaherty’s wishes, that means the bank will likely maintain its overnight rate at the current level for the medium term, while using hints of another rate cut to influence financial markets