OTTAWA - Bank of Canada governor Stephen Poloz says he needs to keep interest rates at historically low levels to head off the risk of a deflationary trap that would have dire consequences for the Canadian economy.
The central banker told a business audience at the Canadian Club in Montreal on Thursday that it may take a couple of years before inflation returns to the two-per-cent target, which he called "sacrosanct."
In fact, Poloz's speech suggests he could be cutting rates right now if he was not fearful of adding more fuel to an already overheated housing market and near record-high levels of household debt.
"Our current monetary policy weighs this risk against the risk of inflation falling even further below target," he said. "This zone of balance is relevant today and in prospect, as we expect both risks to diminish over the next two years or so."
The speech is likely to cement Poloz's reputation as a hawk on inflation, perhaps even more so than his predecessor Mark Carney who, at times, appeared to look through temporary dips and surges in consumer prices.
Poloz argues explicitly that while there are concerns that four years of super-low interest rates could trigger an inflationary spiral, he said "they needn't worry" as he is confident central banks will be able to handle the removal of stimulus in a way that will keep inflation from taking off.
He offers no such clear assurance about deflation, although he believes central banks are keeping it at bay through extraordinary levels of stimulus, including quantitative easing in some countries.
That suggests the Canadian central bank is prepared to keep the trendsetting overnight interest rate fixed at one per cent — where it's been for more than three years — well into 2015 and possibly into 2016 or, if inflation were to fall further, even cut short-term interest rates.
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In October, Poloz broke with his predecessor in dropping the bank's tightening bias, signalling that the bank's next policy move was just as likely to be a cut in interest rates as it was a hike.
Since then, inflation has kept sliding, dipping to 0.7 per cent in October, although underlying price pressures remained more buoyant at 1.2 per cent. Poloz clearly indicates he is concerned it could continue to drop, as happened during the Great Depression and, more recently, in Japan in the 1990s.
"History has taught us that deflation usually comes in the wake of a financial crisis," he said. "Expectations become unanchored on the downside, and people put off their purchases because they expect things to be less expensive later. Demand declines with prices, while the weight of debt on the economy grows."
Poloz made it clear he does not believe such an outcome is the most likely course of the economy. The bank's policy so far is successful in managing both the deflationary and housing risks, he says, nothing that recent evidence suggests the market is heading toward a soft landing.
"I am confident that we've got it roughly right," he said.
In the bank's last monetary policy review, it projected that Canada's economy will grow by 2.3 per cent this year and 2.6 per cent in 2015, and that inflation will return to the two-per-cent target by the latter part of 2015.