The Canadian dollar is falling. Inflation is down to the point where many countries are worried instead about deflation. The economy is getting a boost as the cost of doing business and the cost of living both fall.
Normally we'd associate all three of those things with a cut in interest rates. But this time, just as Bank of Canada governor Stephen Poloz offers his latest thoughts on the state of Canadian monetary policy, those three effects are all being caused not by a cut in rates but by the plunging price of oil. And that complicates the governor's job.
In some ways and in some parts of the country falling oil prices are a big improvement on a rate cut. That may provide only a little comfort to our chief central banker who must break a trail through unfamiliar territory laid with several traps.
I'll start by outlining some of the advantages of falling oil over a decline in rates, chief of which is that lower oil does not force people or businesses to borrow more money to get the benefits. This is important in a country where the rating agency Fitch has described debt levels as "unsustainable."
One of the complications of using interest rates to stimulate an economy is that it encourages people to borrow, leaving an overhang of high-cost debt when interest rates inevitably rise again. Low rates also drive up asset prices, including the price of houses and stocks, disproportionately benefiting the owners of capital and increasing the rich-poor divide.
Cheap oil may not last forever, but for now it gives a fillip to everyone, rich or poor, who drives or heats their home. It lowers the cost of almost everything that is transported long distances, which in a globalized economy is almost everything.
"Lower oil prices will also benefit many sectors, such as manufacturing, by reducing production costs," Timothy Lane, the Bank of Canada's deputy governor, said last week.
Straight to the wallet
The other advantage is that the benefit of lower-priced oil goes straight into the pockets of consumers rather than passing through the hands of bankers who rake off their cut in the lending process and who direct loans, quite reasonably, to those most likely to pay the money back. That may not be the people or businesses that need the money most.
Of course, as mentioned above, Poloz must also face some serious complications in managing monetary policy while taking the stimulative effect of low oil into account.
The most important difference is that unlike a cut in rates, a crash in the price of oil smashes the most dynamic part of the Canadian economy — the oil extraction and exploration sectors. Interestingly, though, the processing sectors of the energy business will also benefit from lower oil. Demand for oil products will rise as prices fall while the cost of feed stock and transportation declines.
But this is small comfort for the integrated petroleum industry and the governments that depend on it for tax and royalty revenue. For the oil-producing provinces, their governments and others that derive their political power there, interest rate cuts could be something they would want. Fortunately, Poloz is above such influence.
Good or bad?
There has been much debate in business headlines over whether falling oil is good or bad for the economy. In fact, it is both. Perhaps the greatest difficulty for Poloz is that while the damaging effect of the oil crash is hitting now, the benefits may not come for as long as a year.
That delayed response is another similarity between rate cuts and the stimulus of lower oil prices. Businesses do not appear overnight. Export growth and increases in consumer confidence are not instant. The process of how rate cuts work their way through the economy is complicated. But if falling oil prices have a similar effect, it is likely the economy won't really kick into gear until at least the end of 2015.
"The maximum effect of a change in interest rates on output is estimated to take up to about one year, and the maximum impact on consumer price inflation takes up to about two years," says the Bank of England report How Monetary Policy Works.
This demonstrates the danger if Poloz should feel pressured into an interest rate cut to boost areas like Saskatchewan, Alberta, and Newfoundland and Labrador, which are already hurting. The stimulative effects of such a rate cut and the oil price decline could well hit at the same time, sending the economy into overdrive in B.C. and the industrial East, and forcing him into a subsequent painful increase in rates.
While the falling price of oil may give some parts of the economy a pick-me-up, that combined with a rate cut could be too much of a good thing.
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