Stephen Poloz says Canadians pay the price for low oil as loonie tumbled: Don Pittis

'We have less spending power today thanwe had before because oil prices are lower, even though you and I aren't oil exporters,'said Bank of Canada governor StephenPoloz yesterday.

It's even worse if you are an oil exporter.

The price of oil,which continued to plunge even asPolozwas speaking, was at the heart of the Bank of Canada's decision not tocut interest rates, even though many expected a cut.

Also for the first time,Poloz made it clear that the Bank of Canadawas prepared to defend the loonie againstagainst rapid declines. The reason was fear of oil-relatedinflation.

• Bank of Canada holds key interest rate steady at 0.5%
• Loonie, stock markets fall as crude dips below $27

Usually the central bank governorresponds to questions about the loonie by sayingits value is not part of the bank's remit. Besides general economic health, the governor's only concern is the level of inflation, using interest rates to keepaverage price rises close to its two per cent target.

Dangerously entangled

But as oil and the Canadian dollarcontinue their tandem descent, suddenly the bank is concerned that the loonieand inflation have become dangerously entangled.

"When [the dollar's decline] happens very quickly, we know it passes through into imported prices and that affects how we measure inflation,"said Poloz. "People see it all at once, and when that happensit's possible that process could begin to influence their expectations of inflation."

We might not realize it, but due to 25 years of discipline by our central bank,Canadians have become convinced that prices dorise, but at a steady annual rate of about two per cent or less. When wesomehowsense they have begun rising too fast, we begin to push for salary increases (or price rises if we are a retailer or service provider)to keep pace.

Poloz made it quite clear he would be willing to boostrates it necessary to protect that 25-year low-inflation legacy.

• Food prices to remain high amid weak dollar, weather-related supply issues

The latest inflation figures are coming out on Friday, but in the most recent dataaverage price increases, while rising, remained well below target at 1.4 per cent. But stories about the doubling price of cauliflower and $3cucumbers may be giving people a magnified view of inflation.

Fully stimulated

The other reason Poloz and the bank's governing council determined not to cut rates is that the economy is already being fully stimulated by low oil prices and the export advantages of alower loonie, which will kick in only gradually.

"The Canadian dollar has declined significantly since October,"Poloz said in his introductory remarks, "which means thenon-resource sectors of our economy are receiving considerably more stimulus than we projected then."

That's why despite all the gloomy news, Poloz remains relatively upbeat about the Canadian economy. While less optimistic about global growth than recent IMF forecasts, the Bank of Canada expects Canada to grow at about two per cent during this calendar year.

Not added into the bank's calculations was the effect of fiscal stimulus promised by the Liberal government, which could boost inflation, but also make future bank outlooks even more optimistic.

That provides little solace to Canada's oil producers.Poloz admits an adjustment process now underway meansthey will continue to suffer as non-resource parts of the economygrow.

"That adjustment process sounds mechanical,"he said sympathetically, "In fact, it's personal."

Poloz expects the resource sector to continue shrinking as producers hit the price threshold below which it is no longer worth extracting oil.

"The lower the price goes, themore you concern yourself with the question, 'What is that threshold?' Some of our oil is quite inexpensive to produce,"said Poloz. "But some of our other oil is much more expensive to produce."

In fact, the multiple extraction and upgrading processes for oilsands bitumenmake it some of the most expensive oil in the world to produce. If the global battle to see who blinks first is based on cost of production, further declines in oil prices are likely to hit us eventually.

Oilsands producer Nexenhas shut down operations at its Long Lake project after an accident, and there is speculation that low prices mean it will not be worth resuming production.

Calgary-basedConnacherhas cut output from its Great Divide oilsands project from 14,000 barrels a day to 3,000, but according to Report on Business journalistJeff Lewis, larger producers can keep losing money for now. That could change if prices drop below $20, he writes.

If that happens, expect to see even more of a two-track economy. But if continued declines in the price of oil causeinflationexpectationsto rise as theloonietumblesrapidly, don't expect more interest rate cuts.

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