Meanwhile...the economy keeps growing

The sun was out and there was a definite hint of spring in the air.  I was feeling pretty good and optimistic about life after coming in from a walk. Then I flipped open my laptop and listened to the Governor’s press conference following his speech in Oshawa.  Wow.  What a downer this guy is becoming and, to boot, he is getting a bit testy when asked about his cautious tone.  It must be frustrating when the mere mortals that make up the economy do not understand the grave danger this economy is in at the present time.   

In brief, there is no change in the Bank’s very dovish view.  The Governor would not even rule out the possibility of rate cuts despite seeing the same positive economic news as the rest of us.  He even told us that a return to normal rates at this point would cause a recession,  although no one I know has suggested that he rapidly push up rates.  

He reminded us all that the Monetary Policy Report is coming out in a few weeks and he will give us his updated assessment then.  However, I would wager that a few weeks are not going to materially change his bias.  Any stronger growth will have reduced excess capacity but it will not have closed the gap.  Against that backdrop, the Governor will stress that core inflation stubbornly remains below target.  Most importantly, the elephant in the room has not left.  It is unlikely that there will be any greater clarity around the timing and specifics of possible US protectionist measures between now and then.

So apart from the Bank being downbeat and remaining dovish, what else did we learn in the press conference and speech? 

We received a concise history of the Canadian economy that highlighted the importance of trade to the country.   

The Governor explained to us that the negative impact from any protectionist’s measures is ridiculously difficult to quantify as behavioural changes and linkages at the micro and macro level are just too complex.  We now know that certain types of increases in protectionism can be modelled, but the degree of uncertainty around the outcome is huge, as in Donald Trump “huge”.   So the potential for a very large negative outcome exists.  The Governor could be uttering a Draghi-like “whatever it takes” to a business audience soon (or not).  

The Governor revealed his thoughts on housing prices.  Apparently, the Bank’s concerns and the actions of various federal government agencies have never been directed at affordability, slowing down the increase in housing prices.  Those nasty increases in the GTA have come about from simple demand/supply dynamics specific to the area.  Strong economic growth in the Toronto region, coupled with immigration are just too much for the available supply.  The Governor did say that there may be some expectational (speculative) buying starting to appear, but that will be monitored.  I am not sure why.  After all, there is nothing the Bank nor OFSI nor DoF can do about that.  Nope, their focus has been on creating the firewall that will ensure that if residential home prices fall, any negative feedback to the financial system will be contained.  When analysts or the media look at ever rising housing prices in the GTA and then conclude the measures taken to date have been ineffective, they are using the wrong metric.  The new rules are helping ensure that the lenders and the borrowers are in a better position to absorb any shock.  As long as stupid prices are not being financed by our financial system, but rather by the bank of mom and/or dad or foreigners, then there is little risk to the economy associated with stupid prices correcting.

  

I continue to struggle with the idea that there is zero risk that a sharp decline in housing prices for a third of the Canadian population will have no negative impact on economic activity and hence on inflation.  The amount of economic resources that have been attracted to housing related activity, let alone any notion of a wealth effect influencing spending do not appear relevant for the Bank’s outlook. Maybe Canada will be “lucky” as the US was in the tech crash of 2000 where the economic fall out of the NASDAQ’s melt down was limited and contained.  But I would point out that monetary policy actions were taken following that crash to clean up.    

What I will take from the Governor’s comments on the housing market is that he remains determined to keep it a financial stability issue and out of monetary policy deliberations.  At the upcoming April meeting, given the risk management framework used when setting policy, they will discuss how much risk weighting they should give to potential US trade measures negatively impacting inflation over the forecast horizon. They will try to quantify something that may or may not happen at some point in the future, neither knowing if protectionist measures will ever be reality, their extent nor the magnitude of any negative impact even if they are implemented.  At the same meeting, there will be no discussion of any possible impact to the economy from a housing price correction in the GTA, a risk that is currently based in reality and building daily, in part driven from “expectational” buying.

So looking at these risks, what most likely comes first?  Sufficient clarity on US trade policy or a correction in housing prices in the GTA?     

   

Housing Bubble? What housing bubble

This week the Bank of Canada had the opportunity to revise its dovish message via a speech given by Deputy Governor Shembri on business investment.   They chose not to budge.  They continued to downplay any recent positive global and domestic economic data, focusing instead on the large difference in the size of the Canadian output gap versus that of our southern neighbour. The Bank remains highly skeptical that Canada “is out of the woods yet”. Too many false starts over the last few years (“serial disappointments”)have obviously scarred Governing Council and has them concerned that the rug will be pulled out from underneath them again.   

Like Bambi staring at the oncoming car lights, the Bank appears frozen, transfixed on geopolitical risks that may include protectionist measures taken against our exports by the new Trump administration sometime in the future.  I am sure their anxiety has even been amped up further following the US refusal to refute protectionism at the recent G-20 meeting, and given hints that the administration is preparing to soon issue the 90 day notice of their intension to revise NAFTA.   

In the meantime, the economy keeps marching on, apparently having found its footings.  The speech mentioned that the worse may be behind the energy sector, that government stimulus will lend support, and that the service side of the economy will contribute to any expansion.  Growth now seems likely to exceed what was outlined in the January MPR when they saw growth at over 2% in 2017 and 2018, above their estimate of potential in both years. 

While the economy moves forward, roughly one third of the population remains subjected to a housing market that refuses to cool.   Any macro prudential measures that have been taken by the federal government and its agencies to date have not been effective.  Recent comments by the Minister of Finance suggest a reluctance to impose more restrictive federal policies on the entire country when it is just a few isolated areas in the country that are experiencing the bubble in prices.  Apparently the fiscal tools at the government’s disposal are just too blunt….so over to you at the provincial level.  Yes, you.  The one with a 12% approval rating.     

The Governor will tell anyone who listens that monetary policy decisions are made within a risk management framework.  His dovish leanings would suggest that he is convinced the economy is operating with significant excess slack and so the downside risk to inflation of a geopolitical event slamming our exports is greater than any significant upside risk to inflation from a stronger than expected economy.  The recently published inflation numbers probably embolden this view for now.  But timing is involved.  The longer it takes to get greater clarity around trade, the more time the economy has to close the output gap and the calculus changes.  At some point, he may have to increase rates, forcing him to later save the exporting community by cutting rates from a higher starting point.  

In the meantime, what harm is there in keeping rates exceptionally low and keeping downward pressure on the currency? It is an easy decision when you put zero weight on the risk of a housing price collapse impacting inflation.  Maybe Governing Council attended the recent Tony Robbins and Pit Bull real estate conference held in Toronto where folks were assured prices can only go up.  Whatever their reasons, in the speech where the Bank outlines the upside and downside risks to inflation, there is no mention of what is going on in that sector.  Why would they (I ask sarcastically)?  I understand that normally the housing market is supported and is vulnerable to the underlying economy.  Their own stress tests show how devastating a loss of employment would be to this sector.  I get it. But with each passing day, housing prices get further away from justifiable levels, having parted ways with the macroeconomic fundamentals that have traditionally explained movements in housing prices.  When asset prices become warped, does causality remain one-way?  I personally find it hard to believe that there is zero risk that a collapse in housing prices, impacting a third of the population will have no impact on the overall economy and, hence, inflation.  I would have thought that is one lesson policy makers would have taken away from the US housing fiasco.  But no, in Ottawa this remains a vulnerability to be discussed only in the Financial System Review.  In other words, it is no doubt a concern, but in their view, certainly not anything that can be addressed with monetary policy.  Better to clean up the mess afterwards than lean into it now with higher rates.  (Again, sarcasm.)The interest rate tool is just too blunt of an instrument ( and where have I heard that before).  Apparently, implicit in the Bank’s actions, with inflationary expectations well anchored, this tool should only be used to keep pressure on the currency to support non-energy exports.

  

Bank of Canada: Financial Conditions too tight...really?

The Bank of Canada left interest rates unchanged this week and opted to remain dovish by highlighting the material excess capacity in the economy, the competitive issues with our exporters and by reiterating the significant uncertainties that could negatively impact the outlook.  Interestingly, they also made mention of the currency and yield levels again, saying they had remained near the levels seen at the last update.  The Governor expressed his unhappiness with these levels in January and apparently is still frustrated, believing they are at levels inconsistent with getting inflation back to target in a timely manner.

Subsequent to the press release, Canadian GDP for the fourth quarter of 2016 was released and came out above the market’s expectations and the Bank’s outlook, with quarterly growth of 2.6% annualized.  Given the Bank’s focus on the diverging economies between Canada and the US, I cannot resist pointing out that his compared to growth south of the border in the same quarter of 1.9%.  Post the release, analysts seem to be divided whether the number exaggerated the underlying strength.   Detractors focused in on the deceleration in domestic demand, while optimists pointed to business investment, the main culprit of the decline in domestic demand, as masking firmness in the other components of output. 

What cannot be said from the numbers is that the level of interest rates is not sufficiently low enough to drive the household sector to spend.  Growth for this sector was concentrated in interest rate sensitive sectors like housing and cars.  Moreover, these yields that may be considered “too high” are an important factor behind a large swath of the population seeing housing prices soar.  Recently released data show an average single detached home in the GTA is now selling for over $1.2 million, an increase of 28% over the last year, and this is spreading as prices in the 905 region increased 35% over the same period.  

However, with respect to business investment, yields and the dollar are obviously not low enough to offset all the costs imposed by competitive disadvantages in this country including regulatory hurdles, environmental studies and uncertainties around the future economic landscape.  Business investment remains very weak and it is doubtful that slightly lower yields and a lower currency would be enough to finally ignite a dramatic reversal in this sector.  The answer to spur more business investment may ultimately lie more on the regulatory and fiscal side. (Watch US economy for further details and results.)

Out of curiosity, it would be interesting to know from the Bank’s models where yields and the currency would need to be before the Governor stopped giving them an honourable mention, when he would consider them to be in sync with getting inflation back to target in a reasonable timeframe.  It would also be interesting to know the size of any reaction to housing prices from the increased incentives to both domestic and foreign buyers.  Unfortunately, I doubt their models include that reality.