Policy in Uncertain Times is...Uncertain

I have to admit the Bank has certainly gone out of its way to clarify and justify its recent shift in policy.  They must have been emotionally stung by accusations that they did not provide the street with sufficient and timely information to ensure that they and the market were on the same page.  Last week’s speech by the Senior Deputy Governor in New York told us that going forward there would be more timely economic updates given around the fixed action dates scheduled between MPRs.  This should help the street align better with the Bank as to where the economy sits at that point in time.  

Notably, the speech also gave us some tips on how to understand and anticipate policy actions during periods of uncertainty.  She explained that they use multiple “competing” models that capture key economic relationships to produce a forecast that include monetary policy actions needed to bring inflation back to 2%.  This forecast is not influenced by uncertainty.  As it was explained, it is like aiming an arrow at the bullseye knowing that the shot will be influenced to some degree by the wind.  It was explained that the Bank will start with a formal framework using this model driven forecast and then apply judgement to account for the “wind” caused by the main sources of uncertainty considered to be missing from the framework.  The effects of these main sources of uncertainty can’t be estimated, as the range of outcomes is too large and statistical estimates based on the past are obviously of little help, unlike their “competing” models that are based on…never mind.     

Policy determination is made even more complex as there will be different policy responses to uncertainty depending on the economy’s initial conditions.  Whenever there is uncertainty, which is all the time, it can either lead to aggressive policy or cautious policy.  We are told that aggressive policy is warranted when rates are near their effective lower bound.  Like now.  Given that the actual neutral rate is likely much lower than the Bank’s 3% estimate, we are definitely in the zone where any negative shock to the economy will be responded to much more aggressively than a positive shock.  At the same time, cautious policy is evidently appropriate when the starting point has inflation resting at the lower end of the target band for some time.  In the Bank’s view, trend inflation at 1.6% is closer to the lower band of 1%, than it is to the 2% target and therefore requires a dovish bias.  My abacus keeps coming up with a different answer, but who am I to argue?

The Bank is now telling us that a cautious approach is appropriate when we are not experiencing a negative shock but are wrestling with an economy growing above potential but whose outlook is plagued by uncertainties around the potential impact on trade of protectionism, past rate increases and macro prudential policies.  Add in some uncertainty around the wage/inflation dynamic and household sensitivity to rising rates and you have a doctor who is backing away from the patient as she is obligated to do no harm.  In this case, taking action may harm both the economy and according to the SDG, the Bank’s reputation.  The “wait and see” approach, we are told, helps avoid abrupt policy reversals.  The Bank seemed quite pleased with itself that since 2000, there had only been 6 abrupt policy reversals.  Maybe that is why we have financial stability issues, but I digress.  The good news is that they just got their abrupt policy reversal out of their system and have shifted to a “wait and see” mode so we don’t have to worry about another abrupt shift, until which time we do.    

So there you have it, all you Bank watchers.  They have come clean on how they make policy decisions in an uncertain environment.  There should be no more surprises.  Don’t go whining to the press if sometime in the future you get tripped up by an unexpected policy shift.  Just emulate the Bank’s competing models that will match the Bank’s imbedded interest rate profile and reverse engineer the MPR to figure out the uncertainty factor.  Then use the Vulcan mind meld on GC to determine the main sources of uncertainty and the appropriate weights that they used to determine that factor.  Finally check the distance the target rate is from the effective lower bound and then determine if the Bank’s view of the current trend of inflation is closer to the 2% target or the upper or lower band.  Don’t be fooled by what simple arithmetic tells you.  Put it all in a bowl, stir vigorously, then rinse and spit.  Out pops the answer.  

The bottom line is that this narrative has been created because it sells, it sounds intuitively right and gives the Bank ample “judgement” room to keep a dovish bias at a time when the economy is at full capacity.  The day will come when another narrative will be conjured up to justify a different policy despite the existence of the same uncertainties.  Of that, I am certain.     

Still Confused

It’s official, the Bank of Canada and its inflation targeting regime is still relevant.  The head guy told us so.  Thank goodness because I am not sure who would hire the 1000 economists working there if they decided to shutter the institution. (Although Finance looks like it needs some good people to explain the implications of making arbitrary and politically motivated changes to tax policy in the name of “fairness”). 

The Governor’s speech earlier this week tried to convince the country that they still have a handle on this inflation targeting stuff.  They remain convinced that the laws of aggregate demand and supply have not been rescinded and remain the fundamental drivers of inflation.   The recent consistent undershooting of inflation in Canada can mostly be explained away by transitory factors.  The Bank, he assured us, understands these fundamental drivers well enough to do policy.   A couple of tenths here and there on inflation are not really relevant in the grand scheme of things.  Being somewhat close to target works in horseshoes, hand grenades and now apparently monetary policy.

The Bank obviously remains confident in the framework it uses to make policy decisions. They expect inflation to trend around the mid-point of their inflation target when the economy is operating at full capacity and inflationary expectations are well anchored.  The fact that trend inflation remains below target and the fact that inflationary expectations are well anchored around the target level, tells them that the economy is not at full capacity yet.  This plus OFSI’s stricter underwriting criteria and the incorporation of some tail risk of Nafta collapsing appears to have led Captain Poloz to set the tasers to caution.  

I can understand there is a lot of noise in the current environment that potentially could lead to a number of outcomes for the economy, both better and worse than currently forecast.  I also get the instinct to do no harm as one tries to separate the signal from the noise and let more data roll in.  

What I don’t understand is a Bank that believes in supply and demand being the fundamental drivers of inflation but shifting to a much more dovish stance, in fact becoming “more preoccupied with downside risks to inflation” when we haven’t been this close to full employment in almost ten years.  The October MPR states that the economy is currently operating close to capacity now and inflation is expected to increase close to 2% over the next six months.  Given that the economy is either at or very close to full capacity, and is expected to grow above potential for the next couple of years, I struggle to reconcile this with a dovish policy setting.  The same guy that says that rate moves need to be done with caution also tells us that “the closer we get to full output and employment, the greater risk that inflation pressures will appear”.  This just seems so inconsistent to me.        

I keep beating the same drum, but to me, there continues to be a large divergence between monetary policy consistent with the gap and the outlook laid out in the MPR (virtually no gap now) and the outlook and the output gap that we are not privy to that seems to be behind the the concern of downside risks to inflation and has prompted a “cautious” policy stance.  If it was any other Governor I would almost think he was trying to keep the currency at bay.  But this Gov?  Naw.