Now What?

Just when it looked like the Bank of Canada may have a strong case to move rates higher, surprisingly soft inflation numbers were posted for May.  Headline inflation came in at 1.3%, the lowest this year, their old measures of core came in below the bottom of their target range at 0.9% and most importantly two of the three amigos (their new three measures of core) lost ground month-over-month, taking the average down to 1.33%.  The deceleration in inflation so far this year would usually be associated with an economy in distress, not one that is growing strongly.  For an inflation targeting central bank with a 2% goal, I confess it is hard to justify moving rates higher in the near term.   But let me try.

Monetary policy is forward looking.  In setting policy, where inflation stands today is less relevant than where inflation is expected to be in six to eight quarters from now when today’s stance will be felt.  Whether to move now depends on the Bank’s conviction that an economy at or near full employment will begin to encounter capacity constraints that will put upward pressure on prices between now and say 18 months from now.  Starting from a low level of inflation may well mean that the extent of total tightening needed to achieve the target may be less and more gradual, but it does not preclude starting the process of reducing stimulus now if they feel the current level of “considerable” stimulus is inconsistent with the current estimated size of the output gap, its pace of closing and what that means for inflation in a year or so. They need to respond today to their call for inflation in the future—not to the current price of oil or the current inflation rate.  

Setting policy based solely on current and volatile economic numbers subjects the Bank to being influenced by noise rather than signal.  The noise tells them that the price of oil is low, inflation is low, etc. but beneath these indicators are strong economic fundamentals that suggest that oil and inflation will find a base and start to move higher well before any tightening action taken by the Bank has any influence over them.  When the market starts to selectively pick the “noise du jour” to forecast upcoming Bank actions, they will always be able to find a reason for the Bank not to do anything.  For example, Canada has had a recent string of very strong economic data.  It is hard to imagine that this momentum can be sustained, especially given softer oil prices.  I can already hear the pundits when the first readings come out that the economy is slowing from its recent pace.  They will immediately insist that the Bank cannot tighten policy.  If they didn’t increase rates when the economy was growing near 3%, why would they now?  

All that being said, my argument that higher rates may be seen sooner rather than later is mute if the Bank has lost confidence in a domestic Phillips curve framework.  Perhaps Canadian  inflation reports are now more heavily influenced by global excess capacity that can be tapped in a cheap and timely manner and are now characterized by a continuum of idiosyncratic deflationary factors (automation, e-commerce, competition) that take turns keeping downward pressure on inflation.  In this case, regardless of the state of our economy relative to its potential growth, global deflationary forces dominate and keep inflation low.  This would suggest very low rates for a very long time and an increased risk to financial stability.  Under this scenario, with high levels of domestic household debt and an aging workforce in the background, there will never be a good time to lessen the level of domestic stimulus as it will always be argued that it is needed to offset these forces as long as they persist.   

So what world does the Bank of Canada believe in?  I think they still give credence to the output gap framework, believing that a domestic economy closing in on full employment will ultimately put upward pressure on prices.  Obviously, the current level of oil and inflation will be inputs into the Bank’s upcoming forecast and will be important factors influencing the profile of economic growth going forward, but their current low levels do not detract from the distance that the economy has already covered in reducing the size of the output gap.  Using this framework, the economy is closer to feeling the impact of domestic capacity constraints on prices than previously expected.  This would suggest to me that the Bank is closer to nudging rates higher than the market expects, despite the recent dis-inflationary readings. 

Will they or Won't They?

Boy can things change in a hurry when it comes to monetary policy expectations.  A few weeks ago the market was convinced that the first upward move in rates in Canada would wait until well into 2018.  In fact, it wasn’t that long ago that visions of rate cuts still danced in the head of the Governor.  Then in mid-month the Senior Deputy Governor acknowledged the stream of positive economic data that has come out over the last few quarters and voila, we suddenly have expectations for a rate hike moved into this year.  Some radicals are even saying there is a chance of a move in mid-July, given the Governor’s history of bold moves.  But wait, there’s more.  Now that the price of oil is suddenly in a bear market and groping for a floor, the take is that this will push any rate hike further back.  After all, they wouldn’t dare be raising rates when oil is at the same price that made them cut rates back in 2015.  What’s a person with a floating rate mortgage to do?

To figure it out, one has to look at where we have been and where we are going with respect to the output gap.  The economy has performed better than the Bank had expected, especially over the last two quarters.  Unless you believe that there has been a matching increase in potential growth, this would lead to a narrower output gap than the Bank expected in its last MPR.  So the starting point for this upcoming decision is from a higher level of GDP and with a smaller output gap.  

In a perfect world, as a policy maker, you would like to have your target rate back to neutral when the output gap is closed.  This would suggest the target rate should be in the neighbourhood of 2.5-3% by early 2018.  That is not going to happen.  We do not live in a perfect world and it is not hard to come up with reasons why rates should remain stimulative to offset numerous headwinds (debt, oil prices, Trump uncertainty, low productivity, blah blah).  The question is, as the Senior Deputy Governor asked, “whether all of the considerable monetary stimulus presently in place is still required?”

The fact that we are probably two quarters away from having the output gap closed, even with the economy slowing from its recent pace would suggest to me that the current degree of monetary stimulus is no longer required.  The Bank acknowledges that growth is broadening and, importantly that the oil price shock is mostly behind us.  This sector that was built on $100 oil has been pared back significantly since 2015 so any impact on the total economy from lower oil prices will be less severe than has been seen in the recent past.  The fact that oil is in the low 40s now is different than two years ago.  The actions that the Bank took in early 2015 are no longer needed.  They can make a very strong case to start the adjustment to higher rates as early as next month.

The adjustment to higher rates started with the Wilkins speech.  The question now is when does the Bank ratify that move and give us some idea of the slope of the increases.  The July MPR gives the Bank the opportunity to act and explain why less stimulus is needed now.  Through its economic projections that will include assumptions around uncertainty, housing, household debt and the currency, they will also give us a sense of the profile of any further rate increases.  My hope is that the Bank does not delay and will start to pull back on the current level of stimulus, getting us closer to an appropriate policy setting.