Market volatility spurred by the U.S. Federal Reserve’s plans to scale back its massive stimulus program is far less of a concern now

By Louise Egan and Randall Palmer

(Reuters) – Market volatility spurred by the U.S. Federal Reserve’s plans to scale back its massive stimulus program is far less of a concern now than it was earlier this year, Bank of Canada Governor Stephen Poloz told Reuters on Tuesday.

Investors understand the Fed’s thinking much better than they did when Chairman Ben Bernanke first mentioned the possibility of tapering the U.S. central bank’s $85 billion in monthly asset purchases on May 22, Poloz said.

The market’s huge one-way bets on the Fed continuing its so-called quantitative easing suddenly had to reverse at that time, causing market turmoil, but Poloz argued that the impact now will be much smaller.

“The good news is that we kind of washed that out last summer. People understand it much better now, and my sense of it is that there isn’t anything like that kind of stacking (leveraging) in the marketplace,” Poloz, 59, said in an interview at the central bank’s Ottawa headquarters.

“So I think that the volatility thing is probably not nearly as concerning as what we saw then.”

In addition, the Fed’s tapering will take place in the context of a strengthening U.S. economy, which should give a lift to Canada’s economy, he said.

A two-day meeting of the Fed’s policymaking Federal Open Market Committee, at which officials could decide to trim the monthly purchases, ends on Wednesday.

While recent strength in the U.S. labor market has raised the chance that the policymakers might start tapering as soon as this week, most economists expect the Fed to keep its stimulus program fully in place until next year.

Turning to Canada, Poloz said the No. 1 risk to the outlook for the domestic economy in 2014 is that exports, which rely heavily on U.S. demand, will not recover as anticipated.

Disappointing exports are a puzzle to Poloz, an expert on trade issues after his 14 years in senior roles at the country’s export credit agency before he became the Bank of Canada governor on June 3.

“About half of our export base is lagging significantly foreign demand and we don’t really understand if it’s because there’s been a structural change,” he said.

It is not clear whether the lag is due to Canadian companies disappearing, losing capacity or simply doing business elsewhere instead of in Canada, he said.

Adding to the export conundrum is business investment, which is lower historically, than it has been following a recession, and inflation that has been below the bank’s 2 percent target for a year and a half.

“Those are three things that are pretty crucial to our economy and how we get back to an inflation target, and in all three cases we’re having trouble explaining what we see,” Poloz said.

The governor also repeated that the central bank had a neutral stance on interest rates. Asked to confirm this meant there was an equal chance of a rate cut as a rate hike, he said: “That’s what neutral would mean. It could also mean that we don’t know which way they would go next.”

The central bank’s policy shift to neutral in October came after 18 months of signaling rate hikes were on the horizon. Although the bank flagged low inflation as a growing worry, it also signaled a reluctance to cut rates for fear of exacerbating record-high household debt. The bank went a step further in December, saying the inflation risk was now greater.

Poloz said he believes Canada’s housing market is in for a “soft landing,” which he defined as stabilization, rather than a decline.

Canada’s housing market avoided the crash experienced in the United States and boomed following the 2008-09 recession, acting as a major driver of growth.

Poloz said that “despite all the excitement” about a possible housing bubble in Canada – some studies have recently shown Canadian housing to be the most over-valued in the world – the activity in the market in the past year has been fairly close to demographic demand.

“All the anecdotes suggest that the supply is being absorbed normally,” he said.

The ratio of household debt to income hit a record high 163.7 percent in the third quarter. While Poloz said it remained a high risk, he also noted it had been rising for a whole generation and at least partially reflected a more mature financial system.

“So there is not really a magic number,” he said.

Poloz said a number of factors that have boosted the Canadian dollar remain in effect: relatively high oil prices, a strong banking system, foreign inflows and the fact some investors view it as a safe haven.

He said the weakening this year in the Canadian dollar may have been caused by sentiment on Fed tapering and a general normalization of the economy.

“If things are going back to normal, there could be a little bit of adjustment in the currency; maybe that’s what we’ve already seen,” he said, adding that he did not want to extrapolate about where the Canadian dollar is now headed.

(Additional reporting by David Ljunggren; Editing by Peter Galloway, Jeffrey Hodgson and Dan Grebler)