Sleepless in Ottawa

When I started this particular post, I was going to address the Governor’s latest speech that described the three things that keep him up at night.  But then along came today’s year-end interview with the Governor in the Globe.  

As per his speech on being sleepless in Ottawa, it struck me that this poor sap is never going to get a full night of REM while he is acting as chief money creator.  For those of you with a life, meaning you missed what he said, the three main concerns he has are cyber threats, high house prices with the associated household debt, and the tough job market for young adults.  His problem beyond apnea is that he will never be able to change the situation.  Casting cyber threats aside, keeping rates at ridiculously low levels to encourage young Karim to tear himself away from a parent’s cooking and laundry service and enter into the workforce will only exacerbate his nightmares about house prices and debt.  Obviously, raising rates to help on the financial stability side will ruin the rest of Karim’s career life.    

The only proper response is a Cpap machine, more Ny-quil and for him to listen to his own advice.  As the Governor himself said in this week’s Globe article, “We said it all along:  we have one instrument - interest rates, and one target - inflation.  All other stuff people would like us to control is not actually our job.  It is a side effect.”  He could have skipped the speech.    

But as I said above, the Globe article stopped me in my tracks.  The piece makes it clear that the he and the market are not seeing eye to eye these days.  He is just as frustrated about communication with the street as the street is with him.  Apparently his shift from forward guidance, where the central bank lays out its intensions over the near term to his “risk management” framework (whatever the hell that is) has not gone as smoothly as he would like.  It has been difficult to shake the market of their habit of expecting him to tell them what to think, while at the same time providing the market the information they need to think for themselves. 

This touched a nerve.  For a long time, this central bank has told the market the framework they use to make policy decisions.  Recently the Senior DG laid out in a speech in New York the sausage-making process that relies heavily on their many models and then adds a few dashes of judgement to address any uncertainties.  The market has access to the same prime ingredients, the incoming data which describes aggregate demand,  the Bank’s latest opinion of the economy’s potential and the objective of the Bank, which is to achieve the 2% inflation target over the medium term.  With all of that, sans forward guidance, the market can make a reasonable forecast of what the Bank will do next, if the Bank itself adheres to the same framework based on quantitative observations.

What the market cannot do is read minds and guess what spices the Colonel is putting into the bucket for this picnic.  According to the article, every decision is now tableau rasa, where they build each statement from the ground up and address areas of uncertainty with their judgement.  Because of the high number of risks and uncertainties in the current environment, there is an inordinate amount of judgement being applied, too much for the market to have a fair chance at guessing what is next.  

The quote above says that the Bank should only be concerned about the inflation target and all the other stuff is not their worry.  So why the long face at Governing Council meetings about Karim, our basement-trapped young adult?  How was the market, from the framework taught to it, to know that GC would suddenly think it is the Bank’s responsibility to keep policy extremely accommodative to give this one select group a little more time to move on up.  It’s not lack of forward guidance or adjusting to a “risk management” approach (whatever the hell that is) that is causing the problem, it is lack of discipline on the part of the Bank as to their own policy framework.

But wait, there’s more.  In the article, the Governor seems to bristle over the fact that the market “over-read” the word “cautiously” in their statement, appearing to think this was a code word for no move.  These market people are such simpletons as “it’s only language” after all.   But how are the simpletons suppose to put that word in context when it is followed up by statements, included in this article, that say the “potential to slip into a deflationary scenario is much more preoccupying.  We need to get ourselves up there for real, and to the 2% zone, so we have room to manoeuvre for the next shock that comes along.”  I admit my simpleton status, but that would suggest to me as long as the Governor doesn’t think 1.6% core inflation is “up there” near 2%, then the hurdle is extremely high to start moving on rates.  Just sayin’. 

All is not lost.  Apparently the Governor believes that the market is finally coming around to better understanding his risk management approach.  He cites the September rate hike when, according to Bloomberg, the bond market had priced in a 50:50 chance of a hike following the release of extremely strong economic numbers just several days ahead of the decision.  He asks out loud how on earth the market could have got it right if the Bank had not been communicating clearly.  I don’t even know where to start with his conclusion.  I would suggest that the market did get it right despite their communication.  The 50:50 odds tell me the market figured out that in this new “risk management” approach (whatever the hell that is), the economic numbers don’t really matter and it’s a toss up as to what this guy will do next. Should make for an interesting New Year.  

I will admit that after reading this article, I have added one more thing that keeps me up at night.

Judgement Days

This week the Bank affirmed its commitment to a cautious, some would say dovish approach to monetary policy.  They made it clear that although interest rate increases will likely be required, they will be executed with caution with an eye on incoming data that will allow the assessment of the economy’s sensitivity to higher rates, the evolution of capacity and the dynamics of wage growth and inflation.   

A large part of their press release was good news.  Synchronized global growth is occurring and domestic growth is moderating but is expected to remain above potential for the second half of the year.  The domestic output is being driven by “very strong” employment growth, increases in wages, higher levels of government spending, and continued business investment.  On the downside, exports are not pulling their weight and housing is adjusting.  As per their target, inflation is higher than expected and even core is firming.  In the past, many of us have seen central banks raise rates after rattling off positive facts like that, particularly when we have been told that we are at or close to full capacity.  

The Bank again said its policy actions will be data dependent but then shows us that it isn’t.  I can’t imagine a tougher time for central bank watchers in this country than now.  Both the Bank and the market see the data at the same time, but the market has no idea how that data will be assessed, weighed by “judgement” that seems contrived to be consistent with GC’s gut feeling. Looking at the preponderance of facts would suggest that we are at at full capacity and at unemployment levels consistent with full employment, seeing wages finally getting some traction and observing the participation rates climbing. This could, at the very least, suggest dropping the cautious stance. But drawing this conclusion from looking strictly at the data is insufficient to align with the Bank’s assessment.  Don’t let facts get in the way of a good story.  In their judgement, there is still ongoing slack in the labour market. Keep the foot on the accelerator.   

Another example is the press release points out that upward revisions to historical national accounts data have left output at a higher level than expected, but their assessment is that this has had no effect on the output gap as the revisions imply the economy’s potential moved up commensurably.  I guess in their judgement, lags between when potential is impacted from any increases in aggregate demand is pretty much simultaneous.  My judgement would be that it is unlikely that newIy hired employees and recently deployed capital would contribute to increasing the country’s potential at the same rate as aggregate demand is moving but my judgement doesn’t matter, only GCs.  This revised data will only give them ammunition to increase potential and move the stop sign further down the road, alluding to my last blog entry. 

Until we decisively break from this period of economics behaving badly (questioning the Phillips curve, the low inflation mystery, uncertainty around trade, etc, etc), the market will continue to be at a high risk of being upended by this central bank.  The Bank tells us that they will be data dependent, but rightly or wrongly, in the current environment, the Bank is instead applying liberal doses of judgement to that data.  So for now, the incoming data should not be viewed as creating a defining, clear landscape picture but should be viewed as an abstract piece of art.  Everyone will look at the same canvas but walk away with a different interpretation.  As the data comes out, feel free to look at the facts and make your own assessment of how the economy is responding to higher rates (is housing slowing due to higher rates or macro prudential measures?), how capacity is evolving and look at the dynamics of wage growth and inflation but whatever conclusions you reach will be your assessment and unlikely to tell you anything about what GC is thinking and is about to do. 

December's Decision

After last Friday’s employment and output data releases, I wonder if the Bank is relieved that the upcoming policy decision is not an MPR.  A few words of acknowledgement here and there in the press release and they can leave rates unchanged.  Nothing to see here, folks.  But I would hope that in the hallowed halls there is a recognition that it just got harder to justify their cautious approach to raising rates by overemphasizing the risks of what might happen versus weighing what is happening.  To remain dovish suggests that the downside risks to future economic performance from potential trade and announced macro prudential measures must have increased to offset any increase in upward price pressures coming from the actual persistent expansion of the economy.  I don’t believe that you can make a solid case that the potential negative impact from these two measures has become more likely or that their outcomes will be worse than previously envisioned a few weeks ago.  What we do know is that if the worse unfolds, the economy will be dealing with these issues from a higher starting point which should give policy makers some comfort.

I think back to the many analogies that the Bank has used; from walking the dog, to cooking spaghetti sauce, to sailing without navigation equipment, to driving a car.  Remember how when you are driving and see a stop sign ahead, you don’t jam on the brakes, you carefully pump the brakes and come to a gentle stop at the intersection.  The Bank was going to appropriately raise rates to slow the economy so that inflation would nestle into the 2% level.  But what do you do if you are so preoccupied by possible collisions that may happen beyond the intersection that you forgot to break appropriately and you now find yourself either in the intersection or through it.  I suppose mere mortals have two choices.  You can now brake and end up somewhere beyond where you were suppose to be or you can keep your foot on the accelerator and continue on in hope that one of the events that you were worried about occurs and is able to slow you down without causing too much damage to the car.  But a central bank is not a mere mortal so the choice most likely to be taken is to convince the market that the intersection was never where the Bank said it was.  You keep telling people that the stop sign is further up the road, so its okay to keep the pedal to the medal and not to worry, that the brakes will be applied at the appropriate time. 

This sounds to me like an accident in waiting.    

Policy in Uncertain Times is...Uncertain

I have to admit the Bank has certainly gone out of its way to clarify and justify its recent shift in policy.  They must have been emotionally stung by accusations that they did not provide the street with sufficient and timely information to ensure that they and the market were on the same page.  Last week’s speech by the Senior Deputy Governor in New York told us that going forward there would be more timely economic updates given around the fixed action dates scheduled between MPRs.  This should help the street align better with the Bank as to where the economy sits at that point in time.  

Notably, the speech also gave us some tips on how to understand and anticipate policy actions during periods of uncertainty.  She explained that they use multiple “competing” models that capture key economic relationships to produce a forecast that include monetary policy actions needed to bring inflation back to 2%.  This forecast is not influenced by uncertainty.  As it was explained, it is like aiming an arrow at the bullseye knowing that the shot will be influenced to some degree by the wind.  It was explained that the Bank will start with a formal framework using this model driven forecast and then apply judgement to account for the “wind” caused by the main sources of uncertainty considered to be missing from the framework.  The effects of these main sources of uncertainty can’t be estimated, as the range of outcomes is too large and statistical estimates based on the past are obviously of little help, unlike their “competing” models that are based on…never mind.     

Policy determination is made even more complex as there will be different policy responses to uncertainty depending on the economy’s initial conditions.  Whenever there is uncertainty, which is all the time, it can either lead to aggressive policy or cautious policy.  We are told that aggressive policy is warranted when rates are near their effective lower bound.  Like now.  Given that the actual neutral rate is likely much lower than the Bank’s 3% estimate, we are definitely in the zone where any negative shock to the economy will be responded to much more aggressively than a positive shock.  At the same time, cautious policy is evidently appropriate when the starting point has inflation resting at the lower end of the target band for some time.  In the Bank’s view, trend inflation at 1.6% is closer to the lower band of 1%, than it is to the 2% target and therefore requires a dovish bias.  My abacus keeps coming up with a different answer, but who am I to argue?

The Bank is now telling us that a cautious approach is appropriate when we are not experiencing a negative shock but are wrestling with an economy growing above potential but whose outlook is plagued by uncertainties around the potential impact on trade of protectionism, past rate increases and macro prudential policies.  Add in some uncertainty around the wage/inflation dynamic and household sensitivity to rising rates and you have a doctor who is backing away from the patient as she is obligated to do no harm.  In this case, taking action may harm both the economy and according to the SDG, the Bank’s reputation.  The “wait and see” approach, we are told, helps avoid abrupt policy reversals.  The Bank seemed quite pleased with itself that since 2000, there had only been 6 abrupt policy reversals.  Maybe that is why we have financial stability issues, but I digress.  The good news is that they just got their abrupt policy reversal out of their system and have shifted to a “wait and see” mode so we don’t have to worry about another abrupt shift, until which time we do.    

So there you have it, all you Bank watchers.  They have come clean on how they make policy decisions in an uncertain environment.  There should be no more surprises.  Don’t go whining to the press if sometime in the future you get tripped up by an unexpected policy shift.  Just emulate the Bank’s competing models that will match the Bank’s imbedded interest rate profile and reverse engineer the MPR to figure out the uncertainty factor.  Then use the Vulcan mind meld on GC to determine the main sources of uncertainty and the appropriate weights that they used to determine that factor.  Finally check the distance the target rate is from the effective lower bound and then determine if the Bank’s view of the current trend of inflation is closer to the 2% target or the upper or lower band.  Don’t be fooled by what simple arithmetic tells you.  Put it all in a bowl, stir vigorously, then rinse and spit.  Out pops the answer.  

The bottom line is that this narrative has been created because it sells, it sounds intuitively right and gives the Bank ample “judgement” room to keep a dovish bias at a time when the economy is at full capacity.  The day will come when another narrative will be conjured up to justify a different policy despite the existence of the same uncertainties.  Of that, I am certain.     

Still Confused

It’s official, the Bank of Canada and its inflation targeting regime is still relevant.  The head guy told us so.  Thank goodness because I am not sure who would hire the 1000 economists working there if they decided to shutter the institution. (Although Finance looks like it needs some good people to explain the implications of making arbitrary and politically motivated changes to tax policy in the name of “fairness”). 

The Governor’s speech earlier this week tried to convince the country that they still have a handle on this inflation targeting stuff.  They remain convinced that the laws of aggregate demand and supply have not been rescinded and remain the fundamental drivers of inflation.   The recent consistent undershooting of inflation in Canada can mostly be explained away by transitory factors.  The Bank, he assured us, understands these fundamental drivers well enough to do policy.   A couple of tenths here and there on inflation are not really relevant in the grand scheme of things.  Being somewhat close to target works in horseshoes, hand grenades and now apparently monetary policy.

The Bank obviously remains confident in the framework it uses to make policy decisions. They expect inflation to trend around the mid-point of their inflation target when the economy is operating at full capacity and inflationary expectations are well anchored.  The fact that trend inflation remains below target and the fact that inflationary expectations are well anchored around the target level, tells them that the economy is not at full capacity yet.  This plus OFSI’s stricter underwriting criteria and the incorporation of some tail risk of Nafta collapsing appears to have led Captain Poloz to set the tasers to caution.  

I can understand there is a lot of noise in the current environment that potentially could lead to a number of outcomes for the economy, both better and worse than currently forecast.  I also get the instinct to do no harm as one tries to separate the signal from the noise and let more data roll in.  

What I don’t understand is a Bank that believes in supply and demand being the fundamental drivers of inflation but shifting to a much more dovish stance, in fact becoming “more preoccupied with downside risks to inflation” when we haven’t been this close to full employment in almost ten years.  The October MPR states that the economy is currently operating close to capacity now and inflation is expected to increase close to 2% over the next six months.  Given that the economy is either at or very close to full capacity, and is expected to grow above potential for the next couple of years, I struggle to reconcile this with a dovish policy setting.  The same guy that says that rate moves need to be done with caution also tells us that “the closer we get to full output and employment, the greater risk that inflation pressures will appear”.  This just seems so inconsistent to me.        

I keep beating the same drum, but to me, there continues to be a large divergence between monetary policy consistent with the gap and the outlook laid out in the MPR (virtually no gap now) and the outlook and the output gap that we are not privy to that seems to be behind the the concern of downside risks to inflation and has prompted a “cautious” policy stance.  If it was any other Governor I would almost think he was trying to keep the currency at bay.  But this Gov?  Naw.  

  

MPR: Is it just me that is confused?

The latest MPR was full of surprises.  Who knew that an over leveraged economy may respond more negatively to higher rates than an economy with less debt?  No sh*t Sherlock.   I wonder who created the incentive to get over leveraged?  According to the document, household debt, in fact, may be so important to consumption and residential investment that the Bank will now incorporate it into their main model.  May we all sleep better knowing this.

However, the real stunner for me was imbedded in the Governor’s opening remarks at the press conference.  He noted that given our recent history of inflation tracking below target, they continue to be more pre-occupied with downside risks to inflation.  As a result, the committee will be cautious in considering future interest rate adjustments and will be guided by incoming data.  This, of course, is the same bunch who gave you two quick hikes in succession over the summer while they were apparently pre-occupied with the downside risks to inflation.

The inconsistency of the Bank is mind blowing.  The distortions needed to be applied to their policy decision framework in order to be consistent with the narrative they want to convey would make a contortionist at Cirque du Soliel blush.  The Bank states in their opening remarks that they have confirmed their faith in their model of inflation, in which inflation depends on the degree of excess demand and excess supply-but operates with a lag.  Well although they go to some lengths in the MPR to convince the market that it is still relevant, as apparently digitalization and globalization impacts are not yet evident in the unexplained portion of inflation, their subsequent statements don’t align well with a central bank that truly believes it.  (To digress, and to paraphrase, I enjoyed it when they noted that globalization has lowered inflation in many advanced economies, but to date Canada does not appear to be an advanced economy.)  

Starting with the output gap closed, their outlook sees growth of 3.1%, 2.1% and 1.5% through 2017-2019, consistently above or at potential.  As currency effects wane, inflation gets back to target a year from now.  But given their professed framework, policy works with a lag, so a decision today will have an impact on inflation in 18 months or so, about six months after inflation has hit the target.  If they truly have faith in their framework and given this as their base case, it is difficult to justify suddenly becoming cautious.  If the framework is valid then their “cautiousness” implies a lack of faith in their forecast.

As has been done many times before by Central banks, they resort to moving the goal posts, tinkering with their decision making framework to justify inconsistent decisions.  They get “cute”.  In the past, this has meant changing in mid-stream the inflation rate they react to to achieve the target headline number.  First it was headline inflation less volatile food and energy, then it was something else and now in Canada it is not one, but rather three ,core rates that they can pick and choose from.  On another occasion, they did the old “switcheroo” by temporarily giving financial stability much more weight in their policy decisions than inflation.  It was suddenly okay to have inflation deviate from target for longer than previously thought acceptable.  Watch me pull a rabbit out of my hat.  This time it is suddenly revealing to the market that there is a difference between full employment and having the output gap closed.      

Since the GFC and through the oil price shock, the market consistently heard from the Bank that policy had to be extremely accommodative given the huge output gap, but that there would come a day when the output gap would close and that monetary policy would need to be tightened.  In theory, at the point of closing, the target rate should be around neutral, which this MPR tells us is around 3%.  And that day has come.  In this MPR, the Bank estimates that for all practical purposes the output gap closed in the third quarter of this year.   But wait a minute.  Just because they say it is probably closed doesn’t mean that it is closed.  No sir.   We are in the sweet spot now.  In a brilliant inversion of Say’s Law (which effectively states that the more men produce, the more they will purchase), we now are being told that demand creates its own capacity to supply almost instantaneously.   The opening statement tells us that every day our economy builds new capacity through new companies, through investment and by hiring.  By their reading the labour market is rife with slack.  I have no doubt that there are still too many teenagers in parents’ basements waiting for those management positions to become available.  Part timers can’t wait to sign on for longer hours and do their part for traffic congestion.  So according to the Bank, we really are not at full employment when the economy is back to a level of output consistent with its potential level.  But if so, this would seem to me to be more of an inherent structural issue with our economy, specifically the labour market and not something that can sustainably be addressed by monetary policy (but I digress).  

The large problem with telling the market that the supply curve is shifting out daily and offsetting any price pressures caused by the higher levels of aggregate demand is that it cannot be collaborated by the evidence.  The Governor, himself, admitted in the press conference that new business creation is disappointing and that business investment is not where it should be at this point of the cycle, weighed down by uncertainties around fiscal and trade policies south of the border.  Moreover, in this country, with all the regulatory and tax disincentives to set up businesses and invest, it is hard to believe that the aggregate supply curve can react as quickly as is being suggested.  

Canadian inflation, like its global counterparts, has been subdued for some time.  Wiser people say its low level is a “mystery”.  To say that you have continued to be pre-occupied with downside risks to inflation and will be cautious in considering future interest rate adjustments right after hiking twice in succession is audacious.  The only two factors that have really changed since we last saw our heroes raise the target rate is the optimism of reaching a NAFTA deal has been shaken and that the volume of those questioning the Phillips curve framework has become louder.  The slow down in growth from the first half was always expected by the Bank when they raised rates and in fact the deceleration so far is slightly less than anticipated and inflation is tracking slightly higher.  In terms of setting policy, the Nafta deal is a tail event and the Bank explicitly tell us that they still believe the output gap framework is valid.

In my years working at the Bank, there were times when I would be frustrated by the amount of spoon feeding that the market demanded.  We would always try to refer the market back to the framework that the Bank operated under.  Inflation targeting central bank, excess supply requires lower rates to put upward pressure on prices, excess demand needs higher rates to dampen inflation, blah, blah.  But this latest MPR will add to the confusion that the market already has with the current Bank regime.  The Bank’s actions and statements are not consistent with the framework they claim they are using.  If future policy actions are the result of “judgement” and are not consistent with what one would expect given the framework, the market is going to experience greater and unnecessary market volatility and ultimately the Bank is going to have a large credibility problem.  Manipulating the rules of the game (framework) and playing with semantics around full employment and a closed out put gap to suit the narrative that your gut tells you is right in a certain environment is not the right recipe for making policy. 

If a rules-based John Taylor doesn’t get the job at the Fed, maybe we could use him up here.        

Historical Yields and Inflation: the Next MPR

The always great FT Alphaville pointed out a recent working paper by the Bank of England that looks at eight centuries of the risk free rate.  (http://www.bankofengland.co.uk/research/Documents/workingpapers/2017/swp686.pdf)  The author builds a data set of the most relevant risk free rate in the world at a particular time, spanning the time period from 1273 to today.  

What does the data show?  Yields generally have ranged between 20% and 1.5% over the period examined.  There have been 9 bull markets in fixed income over that time period lasting anywhere from 10 to 68 years.  The average real yield since 1311 has been 4.78% and has averaged 2.55% over the last 200 years.  Current real rates are ridiculously low.  The author notes that at the end of 2016 the real rate of 0.81% falls short of the 95th percentile thresholds for lowest real rate across the entire data set.  Other fun facts include the absolute bottom in nominal rates occurred in this bull market with US 10 year bonds reaching a low yield of 1.37%.  The last time yields came anywhere close to that was in 1941 when the 10 year touched 1.97%.  As  well, the average length of a bull market on real rates is just short of 26 years.  At 34 years, this current bull market is the second longest.  

There is no doubt, that put into an historical context, nominal and real yields are extremely low.  The fundamentals and more recently the cajoling by central banks to fend off deflation have led to these outlier rates.  

However, what really struck me was the inflation data.  For the last 700 years, inflation has averaged 1.09% and over the last 200 years it has stood at 1.49%, the latter not being far from the current inflation readings in the US and Canada.  I know on their dating profiles our central banks like to take credit for anchoring inflationary expectations but this data would suggest expectations were anchored well before inflation targeting central banks came along. It’s unfortunate for the central banks that inflation may have a “natural” rate well below their 2% target.  You can’t get blood from a stone, so maybe, over the long run, you can’t get sustained inflation to the 2% target level.  No matter how much QE you do.  

As Keynes said, in the long run we are all dead.  So in the meantime we have to deal with central banks that believe they can turn the course of history.  We have to keep playing the game.  

In Canada, we are now “ultra” data dependent (whatever that means, versus being just data dependent).  We just got the inflation reading for September and it appears benign.  The Bank’s favourite measures of core, the three amigos, averaged 1.6%.  This would be .1% above the 200 year average but more significantly still below the Bank’s 2% target.  Although what matters is where the Bank thinks inflation will be in 18 months, the market reads that this will put the Bank on the sidelines on October 25.  Given that the folks on Wellington Avenue are now petrified that some market participants may yell at them again, the odds of the Bank doing nothing are higher than their output gap framework would suggest.  

More government, less hikes?

It’s hard to remain optimistic about Canada’s economy.  We have just posted the strongest growth in the industrialized world but it now looks like our elected officials want to snatch defeat from the jaws of victory.  For political reasons, governments seem to have shifted from ensuring economic growth to ensuring fairness.  After the great run of numbers we just had, most people would want to keep that momentum going.  Sometimes that may mean not rocking the boat and doing nothing.  Unfortunately the words “do nothing” are not in the vocabulary of our political elite unless you are talking about energy infrastructure projects.    

After the surge in growth that we have had, one would expect to see the numbers endogenously soften.  But in addition to this natural slowing, and in the name of helping the middle class, the domestic economy will be expected to shoulder a higher minimum wage in some provinces, a new tax on the small businesses, tighter regulations on non-insured mortgages, and fall-out from the Nafta negotiations that presently appear to be falling apart.  At this stage, it looks like all these measures will be hitting the economy around the same time.  This is on top of current regulations involving the environment that makes it virtually impossible to move forward on any infrastructure project.  Maybe the fact that we are at or near full employment gives the government some room to apply the fiscal and regulatory brakes, but for much of their agenda, they have no clue as to the ultimate impact their new policies will have on the economy, either directly or indirectly.  Consultations that were held with stakeholders on the wage hike, the new tax regime and the mortgage revamp were pretty clear that the first and second round economic consequences may be more negative than expected and there was concern voiced about unintended consequences.  Unfortunately the experts’ concerns fell on deaf ears as both the government and OFSI seem determined to forge ahead with a few possible minor tweaks.  These folks that voiced the possible negative effects obviously had vested interests in the status quo.  You can’t fool our political elite who refuse to let facts get in the way of a good political story.  

So with the governments determined to “rain” on the economic parade (and we haven’t even mentioned present and future hydro rates in the most populated province), how is the central bank suppose to incorporate these measures into their forecast of aggregate demand and longer-term potential growth at the upcoming MPR?  

For the most part, they won’t.  Unless it has been announced as official policy and estimates have been produced by the respective governments as to their impact on the economy and their deficits well before October 25, these overhanging items will not be addressed in the outlook.  This means that the impact of the hikes to minimum wages will be imbedded in the forecast, but nothing else.   

The Bank may make mention about these potential measures in the risks to the inflation outlook, but I doubt it.

Something to keep in mind when we get to look at the economic growth outlook produced for the upcoming MPR and start conjuring up a profile for the target interest rate.   

Central Bank Communication

For Central Bank geeks, last week was eventful.  The head of both the Federal Reserve and the Bank of Canada took to the podium to explain to the market that they have shifted into “grope” mode.  Both institutions have moved well past the point when appropriate policy was obvious which has generally been the case since 2008.   The huge output gap that opened up in the two countries following the financial crisis required nothing but various degrees of ridiculously accommodative monetary policy.  But now, by historical standards, the two economies are at or near full employment.  The only problem is that inflation has not yet responded as one would expect with the gap closed.  This potentially throws the whole Phillips curve framework that the two banks predominately use for policy determination into question.  The confidence that they once held in this framework is being tested.  In this scenario, it is not surprising that they would shift into “grope” mode as the clarity of the environment they are operating in has become murkier.

This new environment is likely to create a gap between what the market has come to expect from central bank communication and what the central bank can provide.  The level of confidence that the proper policy was in place when it was extremely obvious what policy was needed allowed and even forced the central banks to be extremely transparent and explicit.  In the height of the crisis, it gave birth to the idea of forward guidance where central banks promised to keep rates locked at low levels for specific periods of time or until certain economic criteria had been met.  The market was effectively spoon-fed what to expect when it came to rates so there was no reason for the markets to scrutinize the economic data.  The central bank would do the analysis and then tell the market what was next.  

So this week both central banks were very transparent.  From the speeches, the market heard the Fed say that interest rate increases will continue at a slow pace.  On the other side of the border, the market heard the Bank of Canada put a damper on rate hike expectations apparently to ground the high flying loonie.  But I am not sure the market truly heard the subtleties of what was said.  No doubt the market properly interpreted the most likely interest rate path for both countries but I don’t know if they appreciate that the central banks have much less confidence in the interest rate profile that they are suggesting.   Moreover, given that markets are backward looking, the last ten years would suggest the markets’ portfolio of interest rate profiles is likely biased to the downside.  At the same time, a central bank is suppose to be forward looking which would suggest a set of unbiased rate profiles that will allow them to hit their inflation target that has a greater uncertainty band around it.  This means their menu likely includes profiles where rates could go up much quicker than expected by the market but also includes scenarios where they could just as easily go down.  It will depend on the data!    

After almost ten years of being central bank dependent and not data dependent for front end rate determination, it is not surprising to me that the market is struggling a bit with a central bank that can no longer give them the precision that they crave.  It is unrealistic for a central bank to give the market guidance suggesting one interest rate path, when they are less sure of what the appropriate policy is themselves.  As the confidence bands expand around their forecast for inflation, the number of appropriate possible interest rate paths multiply. 

What's he going to say?

The market is breathlessly awaiting to hear from the Governor this week to get a better read of where he stands with respect to policy now that the Bank has moved twice on interest rates and seen the currency appreciate significantly.   After Deputy Governor Lane stunned his prairie audience with a post-speech remark that the Bank would be watching the currency closely post its recent run, I suspect the market will pounce on any glancing comment the Governor makes about CAD. 

As a trader, I get it.  As someone trying to get a grip on future policy decisions, what the currency does over a minute, an hour, a day, a week or even a month is just not that important.   Why is that?  These are periods of time that are too short to have an impact on real growth.  One only has to read Lane’s speech to get an understanding of the number of things other than CAD/US that impact trade over the policy time period that the Bank really cares about.  Not to mention that the exchange rate has implications across the economy not just on trade.  Stronger Canadian dollar..bad for exports (maybe) but good for capital investment (maybe), the two things that the Bank said they would be watching carefully when determining future policy.  

To exaggerate, the market believes that at 1.28, the Bank is content but at 1.22  they are concerned.  The point is that they will only be concerned a quarter to two from now when they have sufficient economic data to tell them that they should have been concerned now.   As Lane said in his speech, but maybe did not emphasize in the Q&A, they will watch how the economy responds to higher rates and a stronger dollar.  They will not base policy on how some people think the economy will respond.  I am not convinced that they have seen enough evidence yet of the impact of this year’s appreciation of the loony on the economy.  They will be watching the data closely (as they always do) as it unfolds over the coming months and their target interest rate will be calibrated to account for the impact sometime in mid 2018, if necessary, to get the economy to glide back down to potential.  

My final observation, again to be found in Lane’s speech, is the graph depicting their new measure of the Canadian effective exchange rate (CEER).   This new measure includes a broader set of countries and accounts for both bilateral trade with another country and the competition Canada faces from other countries that trade in the same good with that country.  So its not just how competitive the going level of CADUS makes us in the US, but also how competitive the peso is making Mexico, for instance, when an importer in America is looking at his/her options.  From a historical perspective, what does the graph going back to 2000 show us?  This new index has traded in a range between 95 and 140.  In the early 2000s, CAD was too weak which led to the creation of a fragile export sector, one that was not based on real economic fundamentals and collapsed quickly when the currency appreciated.  Then just prior to the crisis, the currency was responding to a surge in energy prices and was too strong which resulted in the gutting of even some very competitive firms.  

If history is a guide then, the takeaway is that the index at 95 obviously represents a level that is too weak and at 140 it is obviously too strong.  We are currently sitting just above 120.  It is above the mid point but I wouldn’t want to say that it is in the red zone quite yet. 

What is the Gov going to say?  My bet is that it will be the usual.  He will repeat what was in Lane’s speech, not what was said over coffee.

Off the wall thoughts on the Fed

We are heading into an eventful Fed meeting this week.  The market appears poised for the commencement of the long awaited shrinking of the Fed’s balance sheet.  The prevailing wisdom is the slow unwind of their holdings will not pressure yields higher.   If you are an equity analyst you have priced in that it will never have an impact on yields and if you are involved in credit, you may expect some small effect much later.  So despite the view that there will be little to no impact on yields from this action, the market also seems to be saying to the Fed that a rate hike should not be contemplated in conjunction with the introduction of balance sheet reduction.  

By strictly focusing on inflation readings, I understand why the market does not think a rate hike is needed this week.  But don’t use the new diet of the Fed as an excuse for them not to raise rates if you truly believe this balance sheet action will not have any impact.

This brings me back to focusing on inflation readings.  When it comes to fulfilling the mandates that are given to central banks by their respective elected governments, one could argue that the Fed is closest to ticking off all the boxes and should be the one acting in a relatively more aggressive manner to get rates back to neutral.  Way back when, Congress mandated the Fed to maximize employment, stabilize prices and try to achieve moderate long term interest rates.   With unemployment sub 4.5%, the PCE deflator stubbornly too stable at under 2% and the ten year bond yielding just over 2%, it looks like the overall mandate has already been achieved. 

Unfortunately nothing is that simple.  In 2012, the Fed issued a statement describing its strategy to best achieve the three objectives laid out by Congress.  In it, they stated that their focus would be to achieve and stabilize their favourite measure of inflation around 2%.  If this was met, the other two would fall into place.  

This 2012 statement has the market and, it seems, the Fed preoccupied by the strategy objective of achieving 2% inflation rather than on Congresses’ overall mandate.  This leads all involved to want monetary policy to remain very accommodative in order to nudge inflation slightly higher to attain the arbitrarily chosen 2% target.  But, is there a risk, with inflationary expectations anchored below their target level, that policy starts pushing the other two objectives of the Fed’s mandate away from their optimal levels?   

The most likely case is that we will find out.  The lower probability case is that the Fed starts to recognize that the job they have been given is largely complete and it is time to pick up the pace and get ready to rearm for the next recession.  

Surprise....Again

It has been a while since I wrote a blog.   As the summer began, it looked like the Bank would  duly take back the 50 bp in cuts that it initiated in early 2015 following the oil price shock.  The market was pricing in an increase in July and then again in October.  Following those two moves, many thought the Bank would then be frozen until God knows when.  

Well the market got the July call correct but they underestimated Mr. Poloz’s ability to surprise in September.  A move taken without the publication of the Monetary Policy Review to explain and describe why the action was taken was apparently just too difficult for half of the market to conjure.  Although the initial cut back in January a few years ago was an “out of the blue” surprise, an equally surprising increase was apparently unacceptable.  I am not sure who didn’t learn a lesson from the previous episode, the Bank or the market? 

Some in the market complained that the Bank did not give the market a heads up.  As a result, the price action in the rates and currency market were deemed to be unnecessarily volatile following the decision.  I suppose a wink and a nudge here and there would have prevented people from losing money or losing face.  This forced the Bank to come out and defend themselves for acting without communicating to the market ahead of time its intension to raise rates, saying there normally are no speeches over the dead of summer and the very strong GDP report came out during the black out period.    

Those that complained should be ashamed.  Many need to put their big boy (or girl) pants on.  The July MPR told us that the output gap would likely be closed by the end of this year and the press release told us that the Bank believed that low inflation was temporary and, most importantly, that future adjustments to the target rate would be guided by incoming data.  As we know, that incoming data came in extremely strong, with GDP growth well over 3%, well above what the Bank was expecting and almost twice the pace of the lower band of estimated potential growth!  Bottom line, the output gap, if not already closed now is a breath away, not three months from now as estimated before and the economy still has momentum.  

Market economists have the technology.  They saw the numbers at the same time as the Bank and had the same amount of time to pull out their calculators and do their analysis based on what the Bank had told them just five weeks earlier.  

To be fair, I am sure that many looked at the numbers and concluded that the Bank had good reason to go in September, but immediately started looking for reasons why they wouldn’t given where inflation is tracking.   Current inflation remains well below target so why the rush? 

The rush is that the Bank is targeting inflation two years from now.  As long as they continue to believe in the Phillips curve framework (which the September moves tells us they do), today’s low inflation rate does not get the weight in the decision process that the market continues to believe it does.  For the Bank, what gets more weight is that the output gap is virtually closed now and while growth looks like it will slow, it will continue to track above potential, putting the economy in an excess demand situation early in the New Year.  

Being generous and assuming that the real neutral rate is zero and that inflation remains around current core, this suggests that the Bank would probably like to see a nominal target rate of around 1.5-1.75% at a minimum by early in the new year. 

This shift to higher rates is necessary to glide inflation to its target but it seems like it could be traumatic for market participants.  The Bank will have to hold the market’s hand or maybe even drag it along, but that is where we are headed.  If we can’t get rates closer to neutral now given solid domestic and foreign growth, when will any central bank ever be able to? 

No inflation. Now what do we do?

Inflation is dead, long live inflation.  The implications of this are huge, if true, not just for the markets but for monetary and fiscal policy.  For twenty five years—about a generation—inflation has only been on a declining trend.  Many in the market now cannot even comprehend high inflation as it has never happened in the world they have lived in. Multiple reasons have been put forward to explain its demise, including advances in technology, the expansion to a global labour market, increased competitiveness and free trade.   After so many years of consistently having 1-2% inflation, the memories of higher levels are fading fast, anchoring expectations at very low levels.  Moreover, it appears that the correlation between unemployment and inflation has vanished, sowing doubts about the Phillips curve framework as a guide to monetary policy implementation. In a recent speech, Andy Haldane of the Bank of England noted that the recently observed flat Phillips Curve is akin to the one estimated to exist pre the industrial revolution when laws precluded workers from demanding wage increases.  Vive la change!

I am not convinced that higher levels of inflation can never return.  One would have to rescind the laws of economics and suppose that when global slack is finally absorbed, prices will not respond and be pressured higher.  But for argument’s sake, let’s pretend that inflation is now cemented below the level that many Central banks are targeting.  What then, is an explicit inflation targeting central bank suppose to do?  If inflation is unresponsive to increasing domestic economic growth, why bother keeping the pedal to the metal?  Recent evidence would suggest that keeping rates too low for too long in an attempt to achieve an unattainable inflation target will only cause distortions to financial asset prices.  This increases the vulnerability of the real economy to any sizeable correction in the markets.  If stimulative monetary policy is more effective at generating asset price inflation rather than increasing the general price level, why increase financial stability risk if you are not getting closer to achieving your mandate.    

At this point, it may be relevant to remember the genesis of the 2% inflation target.  The Bank of New Zealand was the first explicit inflation targeting central bank and so it had little guidance in terms of the level they should target.  When their targeting was introduced in December 1990, the ultimate objective was to achieve an inflation rate somewhere between 0-2%.  In 1996, this was subsequently raised to 1-3%.  Both in New Zealand and Canada, the 2% inflation target was chosen, not because it is the optimal level of inflation for the economy to function at its best but because it was deemed to be the best rate of inflation to keep monetary policy relevant and effective. 

The current inflation target was chosen because back in the old days when central bankers thought they were constrained by zero as a bottom to rates, they decided that if inflation was around 2% and they pushed their target rates down to zero, negative real rates of about 2% would be sufficient stimulus, in most cases, to manage the usual downswings of the economy.  

Now if you talk to central bankers, they will tell you that the zero lower bound no longer applies.  At their disposal they have asset purchases and negative interest rates.  Major swaths of the globe now have, or had, negative interest rates and asset purchases and lived to tell the tale.  If quantitative easing and negative rates are ultimately proven to have been effective (jury still out) in stimulating real growth and keeping deflation at bay, then targets of 2% inflation need no longer apply.  With estimates of an effective lower bound somewhere between -0.75 and -1.00%, an inflation targeting central bank could easily lower their explicit inflation target to centre around 1% and still have room to provide sufficient monetary policy stimulus. 

Obviously there are huge implications for a lowering of the inflation target on the economy (in terms of contracts written, etc), on yields and on the Government’s ability to inflate debt away.  That discussion is for another day.

If the structure of the purported new economy drastically decreases the likelihood of inflation climbing above current targets for sustained periods of time, those Bank’s that have explicit target ranges will have to adapt or else lose their credibility.  We may go back to the future and use the 0-2% target initially imposed in NZ instead of our 1-3% range, or drop explicit numbers and go for a less prescriptive target of “low and stable” prices.  Or maybe other central banks will fall in line with the Fed’s original clarified mandate imposed on them in 1977 by Congress before they publicly announced a preferred inflation rate of 2%.  In the original, the Fed was given the goals of maximizing employment, stabilize prices and have moderate long-term rates.  Sort of what they have now.

The Bank of Canada’s inflation target agreement with the Federal government is valid until 2021.  A lot of water will flow under the bridge over the next four years.  But if the global Phillips curve remains flattish and evolving evidence starts to validate the effectiveness of alternative approaches to providing monetary stimulus, lower targets for inflation are a real possibility.  Suddenly current yields on 5 year and 10 year bonds look ever more enticing.  

One down, how many more to go?

So the Bank followed through on their hints and increased their target rate by 25 bp.  If they had not gone, one wonders what the trigger would have been to get them off the sidelines.  But now comes the hard part, determining what will the profile of this hiking cycle look like?  You have a central bank that is behind the curve if their future moves are based on their output gap model and some notion of the Taylor Rule.  This would suggest a more aggressive tightening than the market believes.  At the same time you have a central bank which is confronted by a highly leveraged household sector and inflation that is not responding in textbook fashion to the supposed closing of the output gap.  These latter two are the factors the market is betting on.  The Bank was not very helpful giving guidance, telling us that future actions will be data dependent.   Is the market right?     

There is no doubt that a highly leveraged economy will require a lower terminal target rate of interest to achieve price stability.  But we need to be cognizant of our starting point.  Theory would dictate that the target rate of interest should already be around neutral when the output gap closes.  This is now expected to occur around the end of this year.  Despite a constant lowering of where the neutral rate is over the last number of years, the latest estimate resides around 2.5-3.5%, a long way from 0.75%.  With the gap closed in 6 months, the Bank then sees growth above potential for some time, soaking up labour market excess capacity.  Implicit in this economic outlook is the Bank’s best assessment of the reaction of a highly leveraged economy to higher rates.  In their breakdown of the components of growth, they certainly are in alignment with the market when it comes to direction.  In terms of contribution to average annual GDP growth, consumption is marked down from 1.9% in 2017 to 1.3% in 2018 and 1% in 2019 and housing contributes nothing in the two out years.  So the market must expect the aggregate economy to be much more sensitive to higher rates than the Bank does, who has already marked down contributions to growth from interest sensitive sectors significantly.     

The market is also fixated on today’s stubbornly low inflation.  But as long as the Bank continues to adhere to their output gap based model when making interest rate decisions, they will continue to set policy based on where they believe inflation will be in two years time, not where it is today.  As long as they continue to try to explain away stubbornly low inflation in the face of an output gap that is rapidly closing, it tells me that they still believe in this framework.  In this MPR, they dedicated an entire box (box 2) to explaining the current temporary blips and the Governor, in his opening remarks, made reference that inflation would have been 1.8% if not for one-time factors.   

The big question for the Bank and other central banks is what are the drivers of future inflation.  What are the dominant factors that will determine inflation two years out?  Is domestic inflation predominately determined by domestic factors, or has technology, changes to industrial structures and a more interconnected world increased the influence of global excess capacity on our inflation rate.  The former would suggest inflation moving higher as expected by the Bank, the latter a much more gradual increase.  The market is betting that technology and global excess capacity is a larger influence on future inflation than the Bank believes.

The bad news for the market is that the profile of rates will ultimately be determined by the Bank.  As long as the inflation data can continually be explained away, they will cling to their current framework where future inflation is predominately generated domestically.  This would suggest a more aggressive approach to tightening than the market expects.