What's he going to say?

The market is breathlessly awaiting to hear from the Governor this week to get a better read of where he stands with respect to policy now that the Bank has moved twice on interest rates and seen the currency appreciate significantly.   After Deputy Governor Lane stunned his prairie audience with a post-speech remark that the Bank would be watching the currency closely post its recent run, I suspect the market will pounce on any glancing comment the Governor makes about CAD. 

As a trader, I get it.  As someone trying to get a grip on future policy decisions, what the currency does over a minute, an hour, a day, a week or even a month is just not that important.   Why is that?  These are periods of time that are too short to have an impact on real growth.  One only has to read Lane’s speech to get an understanding of the number of things other than CAD/US that impact trade over the policy time period that the Bank really cares about.  Not to mention that the exchange rate has implications across the economy not just on trade.  Stronger Canadian dollar..bad for exports (maybe) but good for capital investment (maybe), the two things that the Bank said they would be watching carefully when determining future policy.  

To exaggerate, the market believes that at 1.28, the Bank is content but at 1.22  they are concerned.  The point is that they will only be concerned a quarter to two from now when they have sufficient economic data to tell them that they should have been concerned now.   As Lane said in his speech, but maybe did not emphasize in the Q&A, they will watch how the economy responds to higher rates and a stronger dollar.  They will not base policy on how some people think the economy will respond.  I am not convinced that they have seen enough evidence yet of the impact of this year’s appreciation of the loony on the economy.  They will be watching the data closely (as they always do) as it unfolds over the coming months and their target interest rate will be calibrated to account for the impact sometime in mid 2018, if necessary, to get the economy to glide back down to potential.  

My final observation, again to be found in Lane’s speech, is the graph depicting their new measure of the Canadian effective exchange rate (CEER).   This new measure includes a broader set of countries and accounts for both bilateral trade with another country and the competition Canada faces from other countries that trade in the same good with that country.  So its not just how competitive the going level of CADUS makes us in the US, but also how competitive the peso is making Mexico, for instance, when an importer in America is looking at his/her options.  From a historical perspective, what does the graph going back to 2000 show us?  This new index has traded in a range between 95 and 140.  In the early 2000s, CAD was too weak which led to the creation of a fragile export sector, one that was not based on real economic fundamentals and collapsed quickly when the currency appreciated.  Then just prior to the crisis, the currency was responding to a surge in energy prices and was too strong which resulted in the gutting of even some very competitive firms.  

If history is a guide then, the takeaway is that the index at 95 obviously represents a level that is too weak and at 140 it is obviously too strong.  We are currently sitting just above 120.  It is above the mid point but I wouldn’t want to say that it is in the red zone quite yet. 

What is the Gov going to say?  My bet is that it will be the usual.  He will repeat what was in Lane’s speech, not what was said over coffee.

Off the wall thoughts on the Fed

We are heading into an eventful Fed meeting this week.  The market appears poised for the commencement of the long awaited shrinking of the Fed’s balance sheet.  The prevailing wisdom is the slow unwind of their holdings will not pressure yields higher.   If you are an equity analyst you have priced in that it will never have an impact on yields and if you are involved in credit, you may expect some small effect much later.  So despite the view that there will be little to no impact on yields from this action, the market also seems to be saying to the Fed that a rate hike should not be contemplated in conjunction with the introduction of balance sheet reduction.  

By strictly focusing on inflation readings, I understand why the market does not think a rate hike is needed this week.  But don’t use the new diet of the Fed as an excuse for them not to raise rates if you truly believe this balance sheet action will not have any impact.

This brings me back to focusing on inflation readings.  When it comes to fulfilling the mandates that are given to central banks by their respective elected governments, one could argue that the Fed is closest to ticking off all the boxes and should be the one acting in a relatively more aggressive manner to get rates back to neutral.  Way back when, Congress mandated the Fed to maximize employment, stabilize prices and try to achieve moderate long term interest rates.   With unemployment sub 4.5%, the PCE deflator stubbornly too stable at under 2% and the ten year bond yielding just over 2%, it looks like the overall mandate has already been achieved. 

Unfortunately nothing is that simple.  In 2012, the Fed issued a statement describing its strategy to best achieve the three objectives laid out by Congress.  In it, they stated that their focus would be to achieve and stabilize their favourite measure of inflation around 2%.  If this was met, the other two would fall into place.  

This 2012 statement has the market and, it seems, the Fed preoccupied by the strategy objective of achieving 2% inflation rather than on Congresses’ overall mandate.  This leads all involved to want monetary policy to remain very accommodative in order to nudge inflation slightly higher to attain the arbitrarily chosen 2% target.  But, is there a risk, with inflationary expectations anchored below their target level, that policy starts pushing the other two objectives of the Fed’s mandate away from their optimal levels?   

The most likely case is that we will find out.  The lower probability case is that the Fed starts to recognize that the job they have been given is largely complete and it is time to pick up the pace and get ready to rearm for the next recession.  

Surprise....Again

It has been a while since I wrote a blog.   As the summer began, it looked like the Bank would  duly take back the 50 bp in cuts that it initiated in early 2015 following the oil price shock.  The market was pricing in an increase in July and then again in October.  Following those two moves, many thought the Bank would then be frozen until God knows when.  

Well the market got the July call correct but they underestimated Mr. Poloz’s ability to surprise in September.  A move taken without the publication of the Monetary Policy Review to explain and describe why the action was taken was apparently just too difficult for half of the market to conjure.  Although the initial cut back in January a few years ago was an “out of the blue” surprise, an equally surprising increase was apparently unacceptable.  I am not sure who didn’t learn a lesson from the previous episode, the Bank or the market? 

Some in the market complained that the Bank did not give the market a heads up.  As a result, the price action in the rates and currency market were deemed to be unnecessarily volatile following the decision.  I suppose a wink and a nudge here and there would have prevented people from losing money or losing face.  This forced the Bank to come out and defend themselves for acting without communicating to the market ahead of time its intension to raise rates, saying there normally are no speeches over the dead of summer and the very strong GDP report came out during the black out period.    

Those that complained should be ashamed.  Many need to put their big boy (or girl) pants on.  The July MPR told us that the output gap would likely be closed by the end of this year and the press release told us that the Bank believed that low inflation was temporary and, most importantly, that future adjustments to the target rate would be guided by incoming data.  As we know, that incoming data came in extremely strong, with GDP growth well over 3%, well above what the Bank was expecting and almost twice the pace of the lower band of estimated potential growth!  Bottom line, the output gap, if not already closed now is a breath away, not three months from now as estimated before and the economy still has momentum.  

Market economists have the technology.  They saw the numbers at the same time as the Bank and had the same amount of time to pull out their calculators and do their analysis based on what the Bank had told them just five weeks earlier.  

To be fair, I am sure that many looked at the numbers and concluded that the Bank had good reason to go in September, but immediately started looking for reasons why they wouldn’t given where inflation is tracking.   Current inflation remains well below target so why the rush? 

The rush is that the Bank is targeting inflation two years from now.  As long as they continue to believe in the Phillips curve framework (which the September moves tells us they do), today’s low inflation rate does not get the weight in the decision process that the market continues to believe it does.  For the Bank, what gets more weight is that the output gap is virtually closed now and while growth looks like it will slow, it will continue to track above potential, putting the economy in an excess demand situation early in the New Year.  

Being generous and assuming that the real neutral rate is zero and that inflation remains around current core, this suggests that the Bank would probably like to see a nominal target rate of around 1.5-1.75% at a minimum by early in the new year. 

This shift to higher rates is necessary to glide inflation to its target but it seems like it could be traumatic for market participants.  The Bank will have to hold the market’s hand or maybe even drag it along, but that is where we are headed.  If we can’t get rates closer to neutral now given solid domestic and foreign growth, when will any central bank ever be able to?