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.   

If Not Now, When?

This week, there is a high probability that the Bank of Canada will raise interest rates by 25 basis points.  To paraphrase the Governor, he wants to take his foot off the accelerator before the output gap totally closes.  However, according to some articles in the press and some commentary, this may be the beginning of the end for the economy and we are now about to go through the gates of hell.  The world of easy money, as we know it, is over.  You want to buy a house in the GTA?  Wait for two hikes and, according to some, you will be able to scoop them up by the dozen.  One of my favourite headlines was “when rates go up, borrowers will pay”.  That is something new.  Imagine having to pay for the use of money.  Worse still, imagine receiving something on your savings. 

Everyone, take a deep breath and calm down.  

Remember in the great Mel Brooks film Space Balls, Dark Helmut took his Space Ball One ship to “ludicrous” speed.  Well monetary policy, especially in Canada, where we were proud that we never had a systemic financial stability issue,  has been at “ludicrous” speed for the last few years.  Our Dark Helmut is now taking it back to “ridiculous” speed.   Even if rates went up 100 bp from here, monetary policy would still be considered accommodative.  

But according to many, the slightest decrease from “ludicrous” speed is going to risk a destabilizing decline in housing prices and an ensuing banking crisis.  A 50 basis point increase in the five year rate will increase a $250 k mortgage amortized over 25 years by about $70 a month.  About one Starbucks coffee a day.  If an individual has chosen to take on a mortgage payment with no buffer, and a lender has opted to take on this exposure, is it the Bank of Canada’s responsibility to immunize everyone from really bad decisions (or negligent compliance)?

The answer is no.  But they are also aware that when moving rates higher, there will be casualties.  The Bank has spilled plenty of ink on the vulnerabilities emanating from a highly leveraged economy concentrated in the household sector.  They have looked at the impact on the financial system of higher rates and higher unemployment on the sector.  They have determined that the impact of higher unemployment is much more detrimental than when rates increase.  The banking system, along with government regulators,  have also run their own stress tests to determine the impact on them of a housing collapse.  Whether you agree with the results of these stress tests or not, the bottom line is that the Bank does.  It is undertaking the first move, believing that if higher rates ultimately trigger a collapse in asset prices, the financial system would take losses but it would be able to absorb a substantial hit if it were to happen. 

So when the Bank of Canada starts to raise rates, it will be with its eyes on where they expect inflation to be in 18 months to two years.  If they raise rates this week, it is because they believe that the headwinds to achieve their inflation goal have lessened and they can let up on the gas.  They are initiating this move with unemployment at very low levels, reducing the risk of an adverse aggregate impact from housing on the financial system from slightly higher rates.   There could well be some borrowers who will become quickly stressed in the new environment and this will undoubtedly make headlines.  However, as a policy maker charged with setting rates, the focus is not on the individuals who have put themselves in a vulnerable situation but rather on the resilience of the overall economy and the financial system in particular to absorb these losses.  From the work done, the Bank feels confident that the chances of a repeat of the 2008 crisis, where problems in the financial sector propagated back into the general economy, are low.  

So, if the Bank does hike this week, they are starting from a point when the Canadian economy is one of the strongest in the world, unemployment is low (by our standards) and our financial system is resilient.  It would seem to be a good time to start to let up on the pedal.  If not now, then when?