The latest MPR was full of surprises. Who knew that an over leveraged economy may respond more negatively to higher rates than an economy with less debt? No sh*t Sherlock. I wonder who created the incentive to get over leveraged? According to the document, household debt, in fact, may be so important to consumption and residential investment that the Bank will now incorporate it into their main model. May we all sleep better knowing this.
However, the real stunner for me was imbedded in the Governor’s opening remarks at the press conference. He noted that given our recent history of inflation tracking below target, they continue to be more pre-occupied with downside risks to inflation. As a result, the committee will be cautious in considering future interest rate adjustments and will be guided by incoming data. This, of course, is the same bunch who gave you two quick hikes in succession over the summer while they were apparently pre-occupied with the downside risks to inflation.
The inconsistency of the Bank is mind blowing. The distortions needed to be applied to their policy decision framework in order to be consistent with the narrative they want to convey would make a contortionist at Cirque du Soliel blush. The Bank states in their opening remarks that they have confirmed their faith in their model of inflation, in which inflation depends on the degree of excess demand and excess supply-but operates with a lag. Well although they go to some lengths in the MPR to convince the market that it is still relevant, as apparently digitalization and globalization impacts are not yet evident in the unexplained portion of inflation, their subsequent statements don’t align well with a central bank that truly believes it. (To digress, and to paraphrase, I enjoyed it when they noted that globalization has lowered inflation in many advanced economies, but to date Canada does not appear to be an advanced economy.)
Starting with the output gap closed, their outlook sees growth of 3.1%, 2.1% and 1.5% through 2017-2019, consistently above or at potential. As currency effects wane, inflation gets back to target a year from now. But given their professed framework, policy works with a lag, so a decision today will have an impact on inflation in 18 months or so, about six months after inflation has hit the target. If they truly have faith in their framework and given this as their base case, it is difficult to justify suddenly becoming cautious. If the framework is valid then their “cautiousness” implies a lack of faith in their forecast.
As has been done many times before by Central banks, they resort to moving the goal posts, tinkering with their decision making framework to justify inconsistent decisions. They get “cute”. In the past, this has meant changing in mid-stream the inflation rate they react to to achieve the target headline number. First it was headline inflation less volatile food and energy, then it was something else and now in Canada it is not one, but rather three ,core rates that they can pick and choose from. On another occasion, they did the old “switcheroo” by temporarily giving financial stability much more weight in their policy decisions than inflation. It was suddenly okay to have inflation deviate from target for longer than previously thought acceptable. Watch me pull a rabbit out of my hat. This time it is suddenly revealing to the market that there is a difference between full employment and having the output gap closed.
Since the GFC and through the oil price shock, the market consistently heard from the Bank that policy had to be extremely accommodative given the huge output gap, but that there would come a day when the output gap would close and that monetary policy would need to be tightened. In theory, at the point of closing, the target rate should be around neutral, which this MPR tells us is around 3%. And that day has come. In this MPR, the Bank estimates that for all practical purposes the output gap closed in the third quarter of this year. But wait a minute. Just because they say it is probably closed doesn’t mean that it is closed. No sir. We are in the sweet spot now. In a brilliant inversion of Say’s Law (which effectively states that the more men produce, the more they will purchase), we now are being told that demand creates its own capacity to supply almost instantaneously. The opening statement tells us that every day our economy builds new capacity through new companies, through investment and by hiring. By their reading the labour market is rife with slack. I have no doubt that there are still too many teenagers in parents’ basements waiting for those management positions to become available. Part timers can’t wait to sign on for longer hours and do their part for traffic congestion. So according to the Bank, we really are not at full employment when the economy is back to a level of output consistent with its potential level. But if so, this would seem to me to be more of an inherent structural issue with our economy, specifically the labour market and not something that can sustainably be addressed by monetary policy (but I digress).
The large problem with telling the market that the supply curve is shifting out daily and offsetting any price pressures caused by the higher levels of aggregate demand is that it cannot be collaborated by the evidence. The Governor, himself, admitted in the press conference that new business creation is disappointing and that business investment is not where it should be at this point of the cycle, weighed down by uncertainties around fiscal and trade policies south of the border. Moreover, in this country, with all the regulatory and tax disincentives to set up businesses and invest, it is hard to believe that the aggregate supply curve can react as quickly as is being suggested.
Canadian inflation, like its global counterparts, has been subdued for some time. Wiser people say its low level is a “mystery”. To say that you have continued to be pre-occupied with downside risks to inflation and will be cautious in considering future interest rate adjustments right after hiking twice in succession is audacious. The only two factors that have really changed since we last saw our heroes raise the target rate is the optimism of reaching a NAFTA deal has been shaken and that the volume of those questioning the Phillips curve framework has become louder. The slow down in growth from the first half was always expected by the Bank when they raised rates and in fact the deceleration so far is slightly less than anticipated and inflation is tracking slightly higher. In terms of setting policy, the Nafta deal is a tail event and the Bank explicitly tell us that they still believe the output gap framework is valid.
In my years working at the Bank, there were times when I would be frustrated by the amount of spoon feeding that the market demanded. We would always try to refer the market back to the framework that the Bank operated under. Inflation targeting central bank, excess supply requires lower rates to put upward pressure on prices, excess demand needs higher rates to dampen inflation, blah, blah. But this latest MPR will add to the confusion that the market already has with the current Bank regime. The Bank’s actions and statements are not consistent with the framework they claim they are using. If future policy actions are the result of “judgement” and are not consistent with what one would expect given the framework, the market is going to experience greater and unnecessary market volatility and ultimately the Bank is going to have a large credibility problem. Manipulating the rules of the game (framework) and playing with semantics around full employment and a closed out put gap to suit the narrative that your gut tells you is right in a certain environment is not the right recipe for making policy.
If a rules-based John Taylor doesn’t get the job at the Fed, maybe we could use him up here.
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