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?
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