Party On

I really don’t have a life, so for the last few days I have been reading and listening to what government elites and industry titans have been saying at the World Economic Forum in Davos.  You can’t help but feel that most of these participants are almost giddy about the current state of the world.  Global growth is healthy and synchronized and probably most important to these attendees, the markets are soaring around the world.  And with the implementation of US tax changes expected to spur business investment over the near future, many pundits see stocks only going higher regardless of their starting point.

Through headlines, we were reminded by Mr. Dalio of Bridgewater and Mr. Fink of Blackrock that despite the tripling of the S&P since the depths of the great recession, there continues to be ridiculous amounts of liquidity on the sidelines that could potentially be deployed into markets.  Fink told Bloomberg News that in some countries in Europe, around 70% of people’s savings was still held in their banking accounts.  Imagine, he said, if that moved into his business sphere (stocks and bonds) and imagine what that would do to help reduce inequality as these people benefited from rising markets.  (I will give you a moment to gag).  Mr. Dalio suggested that there was a risk we could see a “melt-up” in markets as cash moved in from the sidelines.  He feared that institutions and people left holding cash would feel stupid.  

The only real risks mentioned that could derail these extremely bullish forecasts seemed to be an unanticipated acceleration of inflation or a mistake made by central banks as they try to re-calibrate monetary policy to stronger real growth in highly levered economies.  If rates rise too quickly, all bets are off.

Would one dare suggest that the policy makers may have already made their mistakes?  That the reason for the near euphoria around markets evident at this gathering is because of the sugar rush provided by policy makers when they earlier added three sugar cubes instead of the one that was needed?  A global economy at or near full employment with American fiscal policy soon to kick in does not seem like appropriate, well-timed policy.  A world awash in cash that might yet be put to work in already overvalued equity markets does not seem to be well calibrated global monetary policy.  But these “mistakes” have resulted in an overabundance of “positives”.  What’s there not to like?

It’s the next mistakes that will now have to hurt even more.    

January MPR: No Change, Still Dovish

The Bank raised its benchmark interest rate this week, as many in the market expected.  More surprisingly, the tone from the documents and the press release seemed aligned with market expectations. In the press conference, the Governor seemed pretty pleased with how things evolved, saying the market digested the firmer data as it was released and repriced itself on an ongoing basis, allowing the Bank to ratify the analysis with its increase in the target rate.  That is how it is suppose to happen, he said, when the Bank is data dependent.  

There was nothing that truly stood out from the MPR document.  NAFTA continues to be the fly in the ointment.  The uncertainty surrounding the outcome of the negotiations is already putting a damper on trade and business investment, subduing aggregate demand from where it could be and potentially having a longer-term negative impact on the economy’s capacity to produce.  If the US decides to pull itself out of the negotiations, then all bets are off with respect to the outlook.    

All said, the Bank’s forecast was relatively optimistic, with growth remaining firm and then gradually slowing down to around potential by 2019.  Although the contributors of growth do shift, the overall economy appears to have momentum and be on a firm basis.  The risk to the positive outlook is an exogenous shock. Something like the US pulling out of NAFTA.  

The Governor tried to get ahead of the market, fearing that it may start trading off of Nafta headlines, creating unnecessary volatility by indicating that the Bank would not view this as a binary event. He is right that the decision is not binary.  It will not have a significant immediate impact on the real economy.  Just because one of the participants decides to opt out, the trading world will not cease to exist.  It will potentially take years before the trade framework that replaces NAFTA will be settled on.  But in the meantime, the market will of course remain vulnerable to NAFTA headlines and, being forward looking, will rightfully react on any news as any post-NAFTA trade regime will be sub-optimal to the current one and need some degree of additional monetary stimulus. 

In addition to the NAFTA headlines which will keep risks to front end rates to the downside, there was other evidence that the Bank remains dovish.  They continue to seek reasons to justify not being as aggressive as a pure read of the output gap and the data would suggest.  Governing Council continues to want to believe that we are now in a sweet spot where stronger demand leads to greater supply with increased investment, more business creation and new hires.  They seem to want to let this run as far as they can.  They have come up with a new and improved measure of wage growth, wage-common, that just happens to show that wage growth is slower than normally reported and that the best determinant of this new measure is labour slack.  The fact that this measure is running just above the rate of inflation suggests to them that slack continues to exist. And finally, to stress that point, the Governor again at the press conference defied the analysis of many and said he was still preoccupied with Karim holed-up in his parents’ basement unable to get that job in management.

When you add all of this to their concern about the sensitivity of the leveraged household sector to higher rates, you have a central bank that seems willing to be extremely patient.  It will take some sharp upward surprises for both wages and their core measures before anything close to a hawkish bent makes its way into the building.       

The End of Judgement Days?

Here we go again with the set up for more confusion between the market and the Bank of Canada.  It should be simple.  With core measures of inflation firming at 1.7%, an incredibly strong monthly jobs report diminishing already little remaining excess capacity in the labour market and an economy already at full capacity, it should be a lay-up to expect an inflation targeting central bank that says they are data dependent to nudge rates higher at their next meeting. I know they said they would be cautious when raising rates but surely this is enough, even for this Governor.  

The market has learned over the last few months that Bank action is not strictly data dependent but instead heavily judgement dependent.  The heavy reliance on judgement, we are told, is to allow Governing Council to fill in the blanks caused by the many “uncertainties” that their models just can’t capture.  And so here we are with increasing risks to inflation from a labour market blasting away and about to feel the effects of higher minimum wage legislations, with oil above $60 and with the US economy about to get a fiscal boost, but at the same time with Governing Council having to deal with the same “uncertainties” and structural issues they consistently point to that may dramatically temper any future inflationary impulses.  Nafta could still get pulled, accumulated household debt could adversely impact consumption, OSFI’s new mortgage rules could still flatten the housing market, and, probably coming soon, the legalization of pot could potentially lower productivity (but no one will care).  But besides all these “what ifs”,  this Governor could keep the Bank on the sidelines for the simple reason that youth unemployment did not fall last month….Karim is still in his parents’ basement! 

At some point, however, you would think that the Bank’s own credibility as a forward looking, data dependent inflation targeting central bank will become more at risk.  How far can they push their reliance on their “go-to” list of uncertainties that allow them to justify a level of monetary accommodation that looks more and more targeted to only a few select slices of the economy.  I believe the Governor, in his noble zeal to be the hero of main street is risking giving many people the impression that he is either targeting the currency or unemployment rather than what he is mandated to do.

The Bank, for its own credibility, needs to move rates higher in January.  Responding in a timely and consistent manner to the data will reassure the market that the Bank remains committed to its inflation targeting mandate.  This acknowledgement that risks to inflation have increased and are being addressed will ultimately give the Bank the needed trust from the market to implement appropriate policy that will achieve their 2% inflation target and ultimately get Karim into a management position.