April MPR Assessment

The Bank’s interest rate decision and MPR publication did not shed much light on the future of interest rates in Canada.  The market was told that the economy is in a good place; it is operating around potential, allowing for a continued tightening of the labour market and inflation is bobbing around target.  Governing Council stressed, however, that in order to generate this level of economic activity, stimulative monetary policy is still needed to counteract numerous headwinds.  Obviously as these headwinds dissipate, the target interest rate will need to recalibrate higher.

The list of headwinds is long.  They include the uncertainty around potential trade protectionist measures, how and when housing activity will stabilize following recent OSFI measures, transportation bottlenecks, and international competitive issues including a new US tax regime and higher minimum wage legislation in some provinces.  In his opening statement the Governor said that ultimately rates will need to go up but the pace of the hikes will be “intensely” data dependent.  The magic of projected productivity growth and its resulting marked increase in potential growth gives the Bank a narrative to hide behind that allows them to be patient and be “intense” data watchers.  

So the abatement of these headwinds will ultimately determine the timing of hikes.  For what it is worth, the Bank is expecting growth to pick up smartly in second quarter to 2.5% from 1.3% in the first quarter, as transportation bottlenecks that kept exports from market sort themselves out and as resale activity in the housing market stabilizes.  These are probably the key determinants of a July hike so I will let you decide how quickly you believe these rebound. I am not that optimistic.   

The other headwinds including trade agreements and competitive issues look like they may be with us for longer.  In fact some of the competitive headwinds may actually be structural and be what some politicians believe makes Canada great (or “fair” —unless you are an employer, or consumer, or energy user, or anyone else who benefits from economic activity).  Corporate taxes, regulation and (God forbid) a business friendly atmosphere all lie in the realm of our elected officials.  Unfortunately, history would suggest that these folks are rarely proactive and usually have to wait for a crisis before acting.  I fear these headwinds will continue to blow for some time.

Issues around trade are probably with us for some time as well.  Even a quick Nafta resolution would take time for the Bank to assess.  In the press conference, the Governor noted that although an agreement may spur an improvement in soft data (confidence) and incite some businesses to move forward with investments, they would wait to see the hard data before acting.  Even if an agreement is reached this quarter, that reaffirming data is many months away.   This headwind my hold the Bank back for longer than the market believes.  

For me, given the negatives weighing on aggregate demand, and the fact that through the Bank’s “judgement” they created more excess supply by manipulating potential, tells me that they WANT to be extremely cautious raising rates. This means that if exports don’t pick up soon and if the housing market continues to languish, a July hike is not certain.  I hope I am wrong, but I fear that the profile beyond the next hike is likely to be much flatter than the market expects, taking a long time before we get near 2.5%, the bottom of their neutral rate range.    

Having said all this, the big caveat, and the biggest risk for the market is that the Bank’s judgement of what is going on with the supply side of the economy is wrong and ends up setting the stage for the return of persistent above target inflation.  Potential growth was significantly shifted higher based on historical revisions to the capital stock and on the forecast that future business investment will overcome everything foreign and domestic politicians and regulators have thrown at the economy and instead respond to faint economic fundamentals.

At the extreme, we are dealing with a Governor that seems willing to risk his mandated inflation target to achieve an undisclosed target for the youth participation rate. This is very different from a central bank willing to accept lower employment participation rates in some segments of the labour market to ensure meeting their inflation mandate.    

April MPR

This week, the Bank of Canada will have its interest rate decision and publish its latest update of the Canadian economy’s outlook in the MPR.  The market seems certain that there will be no move on rates and that the update on the economy will exude a neutral odour.  

The economy is at the stage when the closure of the output gap has firmed core inflation to near target, as seen in the Bank’s three measures, but the pressure for inflation to significantly exceed the target in the future is abating as aggregate demand is rapidly softening to potential or below.  In past cycles, the cause of this downshift may have been the result of tighter financial conditions initiated by the Bank but in present day Canada it seems to be more the result of persistent protectionist trade fears and from actions taken by our governments and regulators.

Unless you think our politicians and regulators can get their act together quickly, these downward forces on growth are likely to remain in place for a while.  The recalibration of measures directed toward housing, trade concerns, the absorption of minimum wage hikes, delays around major infrastructure projects and resource production being trapped by transportation bottle necks and poor intra-provincial relations will not be going away anytime soon.

The MPR will give “lip service” to how policy will have to gradually tighten to ensure aggregate demand growth aligns with the potential growth of the economy to ensure the inflation target is maintained sometime out in the future.  But the reality is that much of this “tightening” is being done as a result of actions taken by other authorities.  This puts the onus back onto monetary policy to lean against these negatives to try and keep growth somewhere around potential.  Reality may force the Bank to be more dovish than the market expects.    

Nafta Good, China Bad, Now What?

It was not suppose to be this way.  Remember around the time of Davos when many of the market elites were talking of the equity market “melting up”?  Although no one would consider the market in “melt down”, the air does seems to be coming out of the balloon.  It is still easy to find talking heads that are pounding the table about buying on dips, reminding us of the global synchronized growth and an acceleration of earnings.  Oh and that Trump thing with a trade war with China, no big deal, it is all part of the master plan that the “art-of-the deal” maestro has to make the world a fairer place to barter in.  Besides, they say, cooler and smarter heads will prevail within the White House and pull the President away from doing anything stupid.  Really?  I should remind you that the Obama’s took their dog Bo when they left, so after a number of high profile exits, that just leaves trade savants Wilbur and Bob.     

Many in the market remain convinced that the same guy who brought them tax reform which benefited the market tremendously and might even help the economy, cannot be the same guy that could bring increased taxation through tariffs and hurt the market and maybe even the global economy (despite what Wilbur might say).  What seems to be missing from their analysis is the motivation.  What if the primary motivation for getting tax reform done was political and not economic.  If the true motivation in the White House is to do the right thing for the economy, then this tit-for-tat with China will dissipate as the repercussions quickly become evident.  However, if the motivation is politics and is an attempt to appease his base ahead of November, the risk that this truly becomes a “we’ll show them” trade war over the next six months rises dramatically.   

In the meantime, this just gives the Bank of Canada another legitimate reason to stay on the sidelines.  An unexpected high level provisional agreement on Nafta would certainly be a positive for our economy, but it probably would not be sufficient on its own to immediately boost domestic business investment.   I suspect that the Bank would not get too excited either until they analyzed the economic impact of the deal and had some assurance of any agreement getting through the political process.  The bears will have to remain patient.