Monetary Policy and Housing: Part 2

I was invited the other day to hear a chief economist of one of our major banks give his assessment of the Canadian economy.  The presentation was being given to an audience made up of their retail customers in the Greater Toronto Area.  After giving a thorough talk on everything in Europe, China, the US, which included a large section on Trump and his outlook for Canada, he opened it up for discussion.  It quickly became apparent that all the retail base wanted to hear more on was the housing market in Canada, not more on Trump.  It was all about the housing market, when they should sell, or if they were ever going to be able to buy.  In retrospect, it was not surprising that this was the focus following the presentation as it was also the topic du jour over a glass of wine ahead of the event.  I admit I was taken aback with the amount of emotion surrounding this topic. Bubble anyone? 

Now given that I have a post graduate degree in economics, sadly I guess that makes me an economist.  And according to many central bankers, economists are unable to tell if a particular asset class is experiencing a bubble.  Given no change in aggregate economic fundamentals, but watching housing prices soar relentlessly from a market that clears through frantic bidding wars apparently is no basis to conclude that the market is in a bubble.  This is merely the price that is required to clear a market starved of supply when you have many readied buyers armed with ample credit.  Thank goodness it’s not a bubble.  Because if it was a bubble, the prescription written by the same economists who can’t recognize one is to do nothing.  For them, it is better to remain a Bambi, stay motionless in the lights and then clean up the mess if/when there is an explosion.  This is based on the premise that the potential cost of any clean up to the economy following the bubble popping will be less than the cost imposed by reducing economic activity through higher rates targeted to dampen any perceived bubble. 

This seems to be a hard argument to swallow after the cost we saw imposed on the global economy of a clean up strategy following the housing calamity in the US in 2008.  Unfortunately, we will never know the cost to the economy of what a firmer policy in 2006-7 would have been to make a comparison.  So with no data to refute this chosen protocol, all a central banker can do is stick to the protocol.   The Bank of Canada, by publicly deflecting responsibility of responding to the housing situation to the politicians, is sticking to the central bank handbook and is setting itself up to be Molly Maid if and when the time comes.

However, the results of following the protocol depends on the starting point. If a central bank is limited in its firepower to add stimulus when the blow up occurs, the cost of any clean up risks being larger than if the monetary authorities start with a full chamber, as the recovery will likely be more protracted.   In the current Canadian context, with rates near zero and deficit spending already reducing fiscal capacity, the risk of a long costly clean up rises appreciably.  Policy makers need to acknowledge that the calculus is changing.  With housing prices in a economic significant area of the country increasing by the day, the expected potential cost of any clean up strategy will soon rival any estimated cost to the economy from accepting an inflation rate being below its target for a longer period of time.  

It’s time for the Bank of Canada to be responsible and accountable for the impact of their monetary policy, bubbles and all.  This will require the inclusion of asset price behaviour into their monetary policy decisions and the acceptance that hitting an inflation target in a reasonable period of time at all costs may turn out to be too costly.     

Monetary Policy and Housing: Part 1

It is unfortunate that the Bank of Canada’s next interest rate decision will not be accompanied by a Monetary Policy Report.  Given what has occurred since their last update, it would have been entertaining to see them square the circle.

 When we last heard from the head Sage of Sparks Street, he was stressing the precarious position of the Canadian economy given the potential downsides of a Trump presidency and downplaying any positive effects that may be straying across the border from a stronger US economy.  The Governor appeared petrified to even give a hint of optimism for fear that a resulting stronger Canadian dollar could take inflation further below its target.

Subsequent to those comments, the trade numbers came in better and employment defied gravity, leaving little doubt that the economy has performed better than they had anticipated.    

But maybe the most important development since the last MPR is what is happening in the housing market.  By many standards, real estate prices appear out of control and some pundits have dared to utter the word “bubble”. This has been a perennial concern for the Bank in their Financial System Review but that has not stopped them from keeping the flame burning under the dry kindle hoping inflation would pick up before the wood ignited.  It appears the wood has caught fire.  

In their more recent monetary policy reports, however, they have insisted that any corrective macro prudential actions taken in response to the housing market are best placed in the hands of our elected officials and their agencies.  This allows the Bank to focus on delivering the appropriate policy rate that will solely achieve their inflation target, even if that means over stimulating one sector of the entire economy.  By shunning responsibility to dampen any housing bubble, this frees up the Governor to express his dismay at rising Canadian yields and a “too strong” dollar, as he did at the last MPR.  

The Bank constantly reminds us that monetary policy is a blunt tool, inappropriate to use to address any potential housing crisis, especially when housing prices are acting very differently in different parts of the country.  Can they continue to take this tact, relying on politicians to do the right thing, or is it time that this factor get more weight in their monetary policy decision going forward?   

It’s true that ever rising real estate prices in Vancouver have stalled and are declining following the imposition of a tax on foreign buyers by the provincial government, leaving sky rocketing Toronto housing prices as the outlier.  The problem is that Toronto housing prices are starting to spillover into cities that require over an hour and a half commuting time.  The dramatic price increases are no longer confined to single family homes in a city of 2.5 million, but are now spreading to impact a population approaching 8 million people.  Unlike in BC, where just over 1 million people were being impacted, this is now closing in on 25% of the Canadian population that will make it necessary to devote more of their disposable income and commit to greater amounts of leverage if they want to become home owners. 

Apart from the financial vulnerability that this represents, it also brings with it economic vulnerability.  As a first year economics text book will tell you, labour and capital in the economy get allocated by the pricing mechanism.  Much like higher oil prices spurred a huge reallocation of labour and capital to Alberta that is now being painfully unwound, higher and higher prices in residential investment in Ontario are sucking up resources.  It is no coincidence that one of the strongest contributors to employment growth over 2016 came from finance/insurance/real estate and leasing.  Construction was up there as well.  

To digress a moment.  It seems inconsistent to be concerned about the economic vulnerability created by the hollowing out of our economy when an inappropriately strong dollar causes firms in the export sector to close, but it is okay to encourage a build up in economic activity concentrated around just one sector as a result of an inappropriate interest rate level.  Both create vulnerabilities.

More worrisome for the economy in the longer run is that our resources are “temporarily” being used to support and create non-productive assets.  When the music stops and the air comes out of this bubble, you will be left with an asset that really can’t be used for anything productive.  At least the tech bubble left us some infrastructure for communication and funded some worthwhile research and development.

Already in a low interest rate environment, there is little incentive to invest into productivity enhancing real tangible assets.  Why on earth would any rational economic agent invest in a small start-up anywhere in this country when the easiest way to make money obviously is to lever up and buy a couple of homes in the GTA?

But for the Bank of Canada, the good news is that none of this needs to be addressed directly this time.  And with some timely macro prudential action from the Department of Finance and the Ontario government, this topic may never have to make it back to the MPR forum.  They can stick to do what they do best.  (I am no political analyst but with talk of the federal government thinking of increasing taxes, shocking electrical bills in Ontario and long hospital waiting times, taking action now to reduce home owners’ wealth would seem to require a level of political focus and will that may not be there yet.)     

So as the Bank has continually done, by ignoring the elephant in the room, the press release will be much the same.  They will acknowledge that the economy is a bit better than previously thought but that it is not yet out of the woods.  The volatility of the trade numbers have fooled them before and Trump and his trade policies are still lurking out there in the future.  The risks to inflation are balanced but the downside ones will be in italics.  They will remind us that core inflation (take your pick from their extensive menu) remains below their 2% target and that the  economy continues to have considerable excess capacity.  Despite real world evidence that things may not be that bad, and the glass may be half full, expect to see another press release with Eeeyore’s paws all over it. 

And one final thought in this world of monetary policy decisions being made in a risk management context.  The Bank loves to talk about vulnerabilities and risks, their favourite analogy being a tree with a large crack in the trunk.  This makes the tree vulnerable, but it is not until a storm comes along that the tree topples over and potentially causes damage.  The housing market is vulnerable and its “crack” is getting larger by the day in an economically significant part of the country.  The Governor is continually telling us that the makings of a huge storm is possible given the potential trade policies of the Trump administration.  Is it proper public policy to continue to ignore the expanding housing vulnerability at the same time that you believe there is a heightened downside risk to the economy over the next few months?  At the very least, for the next while, and with one eye on the housing market, maybe its time to drop any talk of interest rate cuts potentially being on the table.

The New Core: Rotten?

Earlier this week, one of the deputy governors gave a speech explaining the Bank of Canada’s new approach to measuring core inflation.  Pretty boring stuff if you are not an economics geek, or if you have a life.  However, the shift in their approach in determining the underlying inflation trend could make it more difficult for market participants to get a timely read on the Bank’s thinking.

 Since 2001, the Bank used CPIX as the measure of core inflation, a proxy for the underlying trend of inflation.  This measure excluded the same 8 components that had been statistically determined to be the most volatile.  However, over time, the Bank became disenchanted with this measure as some of the categories that were not excluded and remained in the core showed that they could also exhibit large transitory shocks.  This could result in core inflation temporarily deviating from the true underlying trend.  Worse, from a modeller’s perspective, this weakened the correlation between their measure of the output gap, whether the economy was in excess demand or supply,  and their measure of underlying inflation. 

 Setting policy off a misleading operating guide could ultimately be costly to the economy.  So the Bank, wanting to improve its ability to separate the signal from the noise, undertook to find the best way to manipulate the CPI data to get a trend rate of inflation more consistent with their theoretical construct of how inflation gets generated.  

The good news for geeks is that they didn’t find just one measure, they found three.  CPIX will now be replaced by CPI-trim, CPI-median and CPI-common.  In short, two of the measures kick out price changes that are considered outliers and the other looks for price changes that are similar across various categories.    

As with CPIX, history shows wide divergences between the three new underlying measures of inflation and the headline number.  The gaps are usually driven by changes to the price of energy.   No surprise there.  What becomes more challenging for central bank watchers is that history also shows episodes where the three new measures diverge from each other.  For example, in the fourth quarter of 2016, the three measures showed that underlying inflation was somewhere in a range between 2.1% and 1.4%.  Apparently, this type of wide divergence is seen by the Bank, not as a weakness, but as a way of giving them additional insight into what is happening to the trend. They say that focusing on just one of these measures would have led them astray in their assessment. 

This leads to one of my issues.  The transparency around how the Bank will arrive at its verdict on the underlying trend of inflation is poor.  They have told us of at least three of the ingredients that will be thrown into the pot, but no idea about the quantities that will give them the mixture that they are looking for, nor do we know if the same recipe will be consistently used.  The cynic in me suggests the recipe followed behind closed doors will be the one that best suits the narrative that the Bank is looking for at the time.  In reality this is not likely to be the case, but how will anyone ever know?  In the example above, with concern about the relative strength of the currency, should we expect more weight to be given to the 1.4% than the 2.1%?

The “read our minds, don’t worry, we know what we are doing” approach versus a verifiable, consistent, publicized operational guide seems like a way that will lead to confusion in the market.  It is also inconsistent with a Bank that complains that the market does not do enough analytical work on their own and relies too much on the Bank.  This new approach appears to give the market no other choice than to rely on the Bank’s analytics.

The Bank has also decided to no longer publish an outlook for core inflation.  Going forward in the MPR, they will only publish a projection of total CPI, as they want to reinforce the headline number as their official target.  I did not realize that there was mass confusion out there in the real world.   Instead, they will include a discussion on the key forces underpinning the inflation process at the time of their analysis.  There will be no profile of projected underlying inflation given to the market to allow them to make any ongoing assessments of whether the Bank’s view on core is developing as expected between MPRs.     

I am probably stretching things, but I will make one final point.  It may be relevant to the market to note that these three new measures of core prices respond less than CPIX to any currency devaluation.   Theory dictates that a move in the exchange rate will have an impact on prices but, since it will be transitory, it does not necessarily warrant a policy response as long as inflation expectations remain well-anchored.  Kicking out any leap in the price of cauliflower that could jar inflation expectations, and numbing the underlying trend of inflation to a currency move, is one more quiver the Bank can lean on to tilt the case towards more desired currency depreciation. 

   

US Protectionism: A one way ticket for the Loonie

In the last few days, the new US administration has accused many of its international trading partners of benefiting from an undervalued currency.  Comments have been made about Mexico, Germany, Japan and China.  The administration’s view seems to be that any country that runs a large trade surplus against the US has been able to accomplish this only as a result of the unfair competitive advantage their cheaper currency has given them.   Since trade is relatively balanced between Canada and the US, we have so far been spared from any tweets proclaiming our currency is too cheap.  This may be disheartening for our Governor. 

To make American economic growth great again, Peter Navarro and Wilbur Ross have focused in on trade in Trump’s  economic plan.  They make the case that by simply eliminating the trade deficit drag on GDP from importing foreign goods, this will translate into faster growth, more jobs and a decrease in public debt.  To them, it’s obvious as the value of imports gets deducted from total GDP.   Replace those nasty subsidized foreign imports with American-made goods and the trade problem vanishes. Rid yourself of the negative and all you have left is the positives.  Brilliant.  Now, to achieve this, renegotiate all the “bad” trade deals signed before, add a few well-placed trade tariffs, include a border adjustment tax in corporate tax reform and keep jaw-boning foreign exchange markets, reminding them that the dollar is overvalued. 

It all seems pretty straight forward.  Will it work?  There is considerable debate amongst economists whether or not it will.  The debate centres on whether the benefit of an increase in aggregate income from the domestic jobs created to replace the missing imports will more than offset the increased costs of higher priced goods.  The conclusion, not surprisingly, from the economics profession is “it depends”.  Michael Pettis’s recent piece, entitled “Is Peter Navarro Wrong?”, explains the conditions that would result in a positive outcome from protectionist measures and those conditions that would result in the opposite.

Sadly, there seems to be no debate on the impact on Canada of US protectionism.  Either a border adjustment tax or the imposition of tariffs are seen as clearly negative.  Dan Ciuriak and Jingling Xiao, in a working paper published by the CD Howe Institute, looked at the impact on Canada if a 10% tariff by the US on all imports was imposed, modelling it after what President Nixon did in the early 70s.  The paper is very detailed in examining the effects, coming to the conclusion that a tariff imposition would reduce the economic welfare of Canada by $33 billion.  Importantly, they also point out that this cost only goes higher if we retaliated by imposing a tariff on the US, as other countries would move in to replace our exports.     

So the US administration could make a plausible case using economic theory that US GDP would respond positively to the introduction of measures to increase the cost of imports, especially if combined with other tax reforms and increased infrastructure spending. 

However, as Pettis points out in his blog, the assumption that trade flows take primacy over capital account flows is dangerous.  Reducing the US trade deficit lessens the flow of US dollars to the rest of the world, importantly decreasing the amount of US dollar funds that can be recycled back into the American economy.  Thus, the administration’s plan appears to be contradictory.  At the same time that they want to force a contraction in the trade deficit, they are increasing the need for dollar funding by encouraging investment through tax reform and infrastructure spending by the private and public sectors. Potentially starving the economy of the funds it may need to achieve the desired level of investment will offset many of the positive effects of their proposed measures. 

So argument can be made from both sides of the protectionist debate for the US economy. The world is too complex to forecast with precision.  However, either way, one can argue that the US dollar will strengthen, even in the face of stiff “tweets”.  If protectionist measures are adopted, any beneficial boost to output will result in a stronger US dollar.  A less positive outcome may also strengthen the dollar, due to the result of higher interest rates caused by a shortage of US dollars to fund any desired expansion. Heads or tails, the argument is there for a stronger US dollar.

The same cannot be said about the Canadian dollar. Whether the US economy gains or loses from any protectionists measures matters little to the size of the hit the Canadian economy will take.  The Governor has recently stated that the currency is too strong now given the current size of the economy’s output gap, let alone post any protectionist measures by the US.  Right now, he would probably love to see the currency weaken and have the “problem” of reading a tweet from the administration claiming the Canadian dollar was undervalued.