How the BoC views the yield curve

Bank of Canada (BoC) governor Stephen Poloz is watching the yield curve to see if its movements align with central bank policy.

The flattening yield curve is “a signal that we would ignore at our peril, because it has a very long history of telling us something important about the economy,” Poloz said Thursday, addressing the CFA Society Toronto with a year-end economic progress report.

However, the curve must be interpreted within the context of the post­–Great Recession economy, he said. For example, as accommodative monetary policy ends, greater market volatility can be expected as risk moves back into the marketplace, off the balance sheets of central banks. Further, global trade concerns add to sector volatility, mostly affecting stocks exposed to trade, he said.

Market recalibration, along with other indicators such as moderating global growth, “are exactly what I would predict from our base profile,” he said. “There’s nothing inconsistent there.”

When asked about liquidity risk in fixed income markets, he referred to the bank’s fixed income forum, through which the central bank consults regularly with major fixed income participants. He described liquidity as “OK,” and said the central bank is “alert to potential issues.”

Bank monitors mortgages, macroeconomics

In his speech, the governor highlighted updates to the central bank’s economic model, which captures how the financial system would affect the real economy and vice-versa, thus helping to inform monetary policy.

For example, the bank now uses a growth-at-risk framework, developed by the International Monetary Fund, to capture the rise in financial vulnerabilities and associated downside risks to economic growth.

The bank also upgraded its economic model to incorporate rising household debt and home prices, and mortgage data analysis to assess how higher rates affect Canadian mortgage-holders.

The governor said the overall level of risk to the Canadian financial system was about the same as it was six months ago when the bank published its financial system review.

As the central bank aims to reach a neutral policy, the governor reiterated concerns about elevated consumer debt from mortgages, which he described as “a vulnerability that will persist for many years.” At the same time, macroprudential measures are improving the quality of that debt, he said.

Though home prices are elevated in markets such as Toronto and Vancouver, he said price growth has decelerated, growing at an annual pace of about 2%—again, because of macroprudential measures along with rising rates. He added that measures to increase housing supply would be the most effective way to support housing affordability.

The governor also outlined macroeconomic risks to its inflation outlook, saying “a lot has happened” since the October monetary policy report, including the release of soft GDP and business investment data, falling prices across both heavy and light oil, and growing concerns about global growth and tariffs.

In particular, oil prices are well below forecast assumptions in the October monetary policy report, and “a painful adjustment” of Western Canada’s economic forecast will affect Canada’s macroeconomy, he said. However, given oil sector consolidation since 2014, net effects of lower oil prices on the Canadian economy, dollar for dollar, should be smaller than in 2015 when oil prices dropped.

Oil and other economic developments will be assessed in new projections in January’s monetary policy report, said Poloz, adding that the pace of interest rate increases to achieve the estimated neutral range of 2.5% to 3.5% would remain data-dependent.

“The persistence of the oil price shock, the evolution of business investment and our assessment of the economy’s capacity will also factor importantly into our decisions about the future stance of monetary policy,” he said.