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.
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