Uncertainty ahead means central banking has to change, Stephen Poloz says

The headwinds that economies still face six years after the financial crisis are a strong argument for changing the way central bankers do their jobs, says Bank of Canada governor Stephen Poloz.

"Thanks to some deft policy-making, the global economy avoided, barely, a second Great Depression,” he said in a speech at Western University on Tuesday.

But many economies, including Canada, remain precarious and now the shock of lower oil prices is making managing financial risk more difficult, Poloz said.

Poloz said central banks were too focused on managing the risk of inflation in the period from 1991 to 2008, leaving them to overlook an important role in managing financial stability.

By financial stability he means risks such as high levels of debt, high levels of leverage by investors and the safety of the country’ s banking system.

It's a balancing act

Poloz says the Bank of Canada has tried since the crisis to rebalance its concern over inflation with its concern over financial stability.

But then came the unknown quantity that threw the system out of whack — a drop in oil prices.

 "The sudden drop in global oil prices has increased both risks. The oil-price shock is an important setback in our progress toward full capacity, full employment and stable inflation because it is a net negative for economic growth," Poloz said.

“And because lower oil prices mean lower Canadian income, the shock will worsen the debt-to-income ratio of Canadian households, thereby increasing financial stability risks.”

Poloz said he dropped the benchmark overnight rate by 25 basis points last month as form of “insurance against both sets of risks.”

That move should cushion the decline in income and employment, and moderate the rise in the debt-to-income ratio that will come with lower oil prices.

Analysts say he's waffling

But Poloz signals there’s still plenty of uncertainty, a form of guidance not well-received by some analysts.

"In our view this says that the Bank of Canada is shifting to data dependency and will condition further possible easing upon how the data and market metrics like oil prices evolve over time," Scotiabank economist Derek Holt wrote in a report to investors.

“That aside, I have difficulty with the BoC’s shifting policy intentions,” he wrote, adding that he believes Poloz is backing off another rate cut, but introducing more uncertainty.

TD economist Brian DePratto agreed that Poloz’s remarks seemed to indicate another rate cut is not a foregone conclusion, as the bank had predicted.

"Governor Poloz's emphasis on the financial stability risks of low interest rates, as well as the statement that "[the January rate cut] buys us some time to see how the economy actually responds", indicate that the Bank of Canada may choose to keep rates on hold at next week's meeting," he said.

A central bank can’t engineer a perfect outcome, only manage risks as they appear in this kind of environment, Poloz said.

The negative effects of lower oil prices are hitting immediately, but any benefits they may have are delayed until Canada’s export capacity rebuilds.

"So, the downside risk insurance from the interest rate cut buys us some time to see how the economy actually responds," Poloz said.

Central bankers are going to have a find a way of living with lower interest rates and thus with less latitude to use the tool of moving rates, he added.

There are also lessons out of the financial crisis to be learned about how global integration and the rise of complex debt instruments can make even strong domestic banking systems vulnerable.

"Policy-makers didn’t fully understand the risks associated with new forms of financial intermediation - complex instruments like collateralized debt obligations. And they didn’t comprehend how interconnected the global financial system had become, and how easily shocks can be amplified and transmitted," Poloz said.