Sleepless in Ottawa

When I started this particular post, I was going to address the Governor’s latest speech that described the three things that keep him up at night.  But then along came today’s year-end interview with the Governor in the Globe.  

As per his speech on being sleepless in Ottawa, it struck me that this poor sap is never going to get a full night of REM while he is acting as chief money creator.  For those of you with a life, meaning you missed what he said, the three main concerns he has are cyber threats, high house prices with the associated household debt, and the tough job market for young adults.  His problem beyond apnea is that he will never be able to change the situation.  Casting cyber threats aside, keeping rates at ridiculously low levels to encourage young Karim to tear himself away from a parent’s cooking and laundry service and enter into the workforce will only exacerbate his nightmares about house prices and debt.  Obviously, raising rates to help on the financial stability side will ruin the rest of Karim’s career life.    

The only proper response is a Cpap machine, more Ny-quil and for him to listen to his own advice.  As the Governor himself said in this week’s Globe article, “We said it all along:  we have one instrument - interest rates, and one target - inflation.  All other stuff people would like us to control is not actually our job.  It is a side effect.”  He could have skipped the speech.    

But as I said above, the Globe article stopped me in my tracks.  The piece makes it clear that the he and the market are not seeing eye to eye these days.  He is just as frustrated about communication with the street as the street is with him.  Apparently his shift from forward guidance, where the central bank lays out its intensions over the near term to his “risk management” framework (whatever the hell that is) has not gone as smoothly as he would like.  It has been difficult to shake the market of their habit of expecting him to tell them what to think, while at the same time providing the market the information they need to think for themselves. 

This touched a nerve.  For a long time, this central bank has told the market the framework they use to make policy decisions.  Recently the Senior DG laid out in a speech in New York the sausage-making process that relies heavily on their many models and then adds a few dashes of judgement to address any uncertainties.  The market has access to the same prime ingredients, the incoming data which describes aggregate demand,  the Bank’s latest opinion of the economy’s potential and the objective of the Bank, which is to achieve the 2% inflation target over the medium term.  With all of that, sans forward guidance, the market can make a reasonable forecast of what the Bank will do next, if the Bank itself adheres to the same framework based on quantitative observations.

What the market cannot do is read minds and guess what spices the Colonel is putting into the bucket for this picnic.  According to the article, every decision is now tableau rasa, where they build each statement from the ground up and address areas of uncertainty with their judgement.  Because of the high number of risks and uncertainties in the current environment, there is an inordinate amount of judgement being applied, too much for the market to have a fair chance at guessing what is next.  

The quote above says that the Bank should only be concerned about the inflation target and all the other stuff is not their worry.  So why the long face at Governing Council meetings about Karim, our basement-trapped young adult?  How was the market, from the framework taught to it, to know that GC would suddenly think it is the Bank’s responsibility to keep policy extremely accommodative to give this one select group a little more time to move on up.  It’s not lack of forward guidance or adjusting to a “risk management” approach (whatever the hell that is) that is causing the problem, it is lack of discipline on the part of the Bank as to their own policy framework.

But wait, there’s more.  In the article, the Governor seems to bristle over the fact that the market “over-read” the word “cautiously” in their statement, appearing to think this was a code word for no move.  These market people are such simpletons as “it’s only language” after all.   But how are the simpletons suppose to put that word in context when it is followed up by statements, included in this article, that say the “potential to slip into a deflationary scenario is much more preoccupying.  We need to get ourselves up there for real, and to the 2% zone, so we have room to manoeuvre for the next shock that comes along.”  I admit my simpleton status, but that would suggest to me as long as the Governor doesn’t think 1.6% core inflation is “up there” near 2%, then the hurdle is extremely high to start moving on rates.  Just sayin’. 

All is not lost.  Apparently the Governor believes that the market is finally coming around to better understanding his risk management approach.  He cites the September rate hike when, according to Bloomberg, the bond market had priced in a 50:50 chance of a hike following the release of extremely strong economic numbers just several days ahead of the decision.  He asks out loud how on earth the market could have got it right if the Bank had not been communicating clearly.  I don’t even know where to start with his conclusion.  I would suggest that the market did get it right despite their communication.  The 50:50 odds tell me the market figured out that in this new “risk management” approach (whatever the hell that is), the economic numbers don’t really matter and it’s a toss up as to what this guy will do next. Should make for an interesting New Year.  

I will admit that after reading this article, I have added one more thing that keeps me up at night.

Judgement Days

This week the Bank affirmed its commitment to a cautious, some would say dovish approach to monetary policy.  They made it clear that although interest rate increases will likely be required, they will be executed with caution with an eye on incoming data that will allow the assessment of the economy’s sensitivity to higher rates, the evolution of capacity and the dynamics of wage growth and inflation.   

A large part of their press release was good news.  Synchronized global growth is occurring and domestic growth is moderating but is expected to remain above potential for the second half of the year.  The domestic output is being driven by “very strong” employment growth, increases in wages, higher levels of government spending, and continued business investment.  On the downside, exports are not pulling their weight and housing is adjusting.  As per their target, inflation is higher than expected and even core is firming.  In the past, many of us have seen central banks raise rates after rattling off positive facts like that, particularly when we have been told that we are at or close to full capacity.  

The Bank again said its policy actions will be data dependent but then shows us that it isn’t.  I can’t imagine a tougher time for central bank watchers in this country than now.  Both the Bank and the market see the data at the same time, but the market has no idea how that data will be assessed, weighed by “judgement” that seems contrived to be consistent with GC’s gut feeling. Looking at the preponderance of facts would suggest that we are at at full capacity and at unemployment levels consistent with full employment, seeing wages finally getting some traction and observing the participation rates climbing. This could, at the very least, suggest dropping the cautious stance. But drawing this conclusion from looking strictly at the data is insufficient to align with the Bank’s assessment.  Don’t let facts get in the way of a good story.  In their judgement, there is still ongoing slack in the labour market. Keep the foot on the accelerator.   

Another example is the press release points out that upward revisions to historical national accounts data have left output at a higher level than expected, but their assessment is that this has had no effect on the output gap as the revisions imply the economy’s potential moved up commensurably.  I guess in their judgement, lags between when potential is impacted from any increases in aggregate demand is pretty much simultaneous.  My judgement would be that it is unlikely that newIy hired employees and recently deployed capital would contribute to increasing the country’s potential at the same rate as aggregate demand is moving but my judgement doesn’t matter, only GCs.  This revised data will only give them ammunition to increase potential and move the stop sign further down the road, alluding to my last blog entry. 

Until we decisively break from this period of economics behaving badly (questioning the Phillips curve, the low inflation mystery, uncertainty around trade, etc, etc), the market will continue to be at a high risk of being upended by this central bank.  The Bank tells us that they will be data dependent, but rightly or wrongly, in the current environment, the Bank is instead applying liberal doses of judgement to that data.  So for now, the incoming data should not be viewed as creating a defining, clear landscape picture but should be viewed as an abstract piece of art.  Everyone will look at the same canvas but walk away with a different interpretation.  As the data comes out, feel free to look at the facts and make your own assessment of how the economy is responding to higher rates (is housing slowing due to higher rates or macro prudential measures?), how capacity is evolving and look at the dynamics of wage growth and inflation but whatever conclusions you reach will be your assessment and unlikely to tell you anything about what GC is thinking and is about to do. 

December's Decision

After last Friday’s employment and output data releases, I wonder if the Bank is relieved that the upcoming policy decision is not an MPR.  A few words of acknowledgement here and there in the press release and they can leave rates unchanged.  Nothing to see here, folks.  But I would hope that in the hallowed halls there is a recognition that it just got harder to justify their cautious approach to raising rates by overemphasizing the risks of what might happen versus weighing what is happening.  To remain dovish suggests that the downside risks to future economic performance from potential trade and announced macro prudential measures must have increased to offset any increase in upward price pressures coming from the actual persistent expansion of the economy.  I don’t believe that you can make a solid case that the potential negative impact from these two measures has become more likely or that their outcomes will be worse than previously envisioned a few weeks ago.  What we do know is that if the worse unfolds, the economy will be dealing with these issues from a higher starting point which should give policy makers some comfort.

I think back to the many analogies that the Bank has used; from walking the dog, to cooking spaghetti sauce, to sailing without navigation equipment, to driving a car.  Remember how when you are driving and see a stop sign ahead, you don’t jam on the brakes, you carefully pump the brakes and come to a gentle stop at the intersection.  The Bank was going to appropriately raise rates to slow the economy so that inflation would nestle into the 2% level.  But what do you do if you are so preoccupied by possible collisions that may happen beyond the intersection that you forgot to break appropriately and you now find yourself either in the intersection or through it.  I suppose mere mortals have two choices.  You can now brake and end up somewhere beyond where you were suppose to be or you can keep your foot on the accelerator and continue on in hope that one of the events that you were worried about occurs and is able to slow you down without causing too much damage to the car.  But a central bank is not a mere mortal so the choice most likely to be taken is to convince the market that the intersection was never where the Bank said it was.  You keep telling people that the stop sign is further up the road, so its okay to keep the pedal to the medal and not to worry, that the brakes will be applied at the appropriate time. 

This sounds to me like an accident in waiting.