On a chilly December morning last year, attendees packed into the Grand Ballroom at the Marriott Downtown in Toronto to uphold a decades-old tradition of hearing the Governor of the Bank of Canada (BoC) deliver his final update for 2018.

In his introduction, Governor Stephen S. Poloz reminded the audience that the BoC had been awarded Bank of the Year for 2018. He then flashed the new $10 vertical bank note featuring Viola Desmond (a businesswoman of Black Nova Scotian descent, who, in 1946, refused to leave a whites-only area of the Roseland Theatre in New Glasgow, N.S.) and joked that the BoC had been recognized even before it introduced the bill into circulation.

We’ll consider Poloz’s presentation with a view to understanding whether—aside from launching such a notable and noteworthy currency—the BoC was fully deserving of the title Bank of the Year.

Applying theory to practice

For anyone learning monetary policy theory or looking for a refresher on the interactions between interest rates, inflation, and the economy, Poloz’s presentation was an example of how to apply these fundamental financial concepts. In setting the stage, he reminded the audience of three points: the economy has been operating at near capacity for more than a year, employment is at a 40-year low, and inflation is on target. This would suggest that the economy is at the point in the cycle when inflation pressures start to build and policy-makers start looking to move interest rates to a neutral level.

However, monetary policy is more complicated, given the build-up of household debt and large increases in house prices—especially in Canada’s largest cities. Poloz noted that even while debt is expected to build up during the recovery phase of the economic cycle as low interest rates encourage households and firms to borrow, the past 10 years have been far from normal. Interest rates have been extraordinarily low for an extraordinarily long time, and household debt has accumulated to historic proportions. This level of debt requires close monitoring.

Poloz’s views on rising house prices and affordability are rooted in supply and demand. The increase in demand and subsequent pressure on prices is supported by strong fundamentals: population growth and increase in the costs of inputs. Policies such as the newly introduced stress tests to ensure borrowers can withstand an increase in interest rates are expected to dampen any speculation (i.e., demand pressures). However, in his view, measures to increase the supply of housing would be the most effective way to improve affordability—perhaps by passing the buck to other parts of the government, given that these measures are largely out of the BoC’s control.

Being transparent

Any central bank that’s recognized as “Bank of the Year” has likely been transparent about its processes and expectations. Poloz was open about how the risks the BoC is tracking, and how financial stability concerns, are reflected in the decision-making process.

As risk relates to the build-up of household debt, Poloz acknowledged that most households today are renewing at rates similar to what they signed up for five years ago, but that, going forward, there’ll be a larger gap when borrowers renew. This is a risk the BoC continues to track and model. Along with this risk, the BoC is paying closer attention to the portion of mortgages that originate outside of federal jurisdiction—including private lenders or credit unions. This figure is rising, especially in the Toronto area. Recent policy changes that were introduced to increase the resilience of future borrowing and debt service don’t apply to these borrowers. The BoC is also seeing a greater share of highly indebted borrowers taking out variable rate mortgages. So, while overall actions have been taken to improve the quality of lending, the inventory of risky mortgages remains high.

Global bond markets are also top of mind, given recent bond and equity market volatility and the statistics that suggest Canada typically imports 60 to 70 percent of any risk in global bond yields. The main catalyst for this risk would be an inflation surprise from the U.S.; incidentally, the probability of this has increased of late, given the response of the U.S. economy to fiscal stimuli.

To manage future expectations, Poloz suggested that policy interest rates will need to rise to a neutral range (two to three percent) in order to achieve the inflation target. He reminded the audience that the pace at which this rise occurs will depend on data, like the risk levels mentioned earlier. In the meantime, the BoC will continue to gauge the impact of higher interest rates on consumption and housing, and will continue to monitor global trade developments.

Incorporating modern ideas

Finally, a central bank worthy of being the “best” has likely implemented some modern ideas into its approach to monetary policy (beyond introducing a vertical bank note highlighting a notable female historical figure). Poloz described his utopian “grand synthesis” model, which reveals how developments in the financial system reflect the real economy and the risks it faces—and vice versa. While he acknowledged this ideal model may never be realized, he did note that the BoC has introduced some new approaches to bring it closer to this paradigm. These include the following:

1. BoC staffers now use a “growth-at-risk” concept (developed at the IMF) to understand the links between the financial sector and the real economy. When contemplating a change in interest rates, they can now assess the usual direct effects on the economy and also look at the indirect effects of financial vulnerabilities more rigorously.
2. The BoC has upgraded its main economic model to incorporate household debt accumulation in order to reflect that the economy is more sensitive to interest rate movements when debt levels are high and to recognize the link between debt accumulation and rising housing prices.
3. Finally, BoC staffers are working with new sources of micro data to deepen their understanding of how higher interest rates affect mortgage holders. They have access to anonymous data at the individual loan level, which allows them to calculate how households are affected by rising interest rates through the whole mortgage cycle and to assess the impact of rising rates on expenses and spending.

Given the BoC’s practical, transparent, and modern approach, which Poloz described, it’s understandable why it was awarded Bank of the Year. Despite the risks and vulnerabilities in the economy, one would hope these preventative and measured approaches will help to mitigate any substantial risks that might emerge with rising household debt and growing concern over the global bond markets. However, given that these risks haven’t materialized yet, only time will reveal whether Poloz and the BoC were aptly awarded ahead of their time or, unfortunately, recognized before real-life conditions could test their approach.

Click here to watch Poloz’s full presentation.