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.    

Inflation at target? Not my problem

Well this is a bit awkward.  Just as our hero told us he was putting on his cape and was going to save the world, or at least Canada, by allowing the economy to run hot to encourage greater employment inclusion, he got news that inflation is already at target.   Headline is running the fastest it has since 2014 and even the three amigos, the three measures of core are averaging  2%, right at target.   With other gauges apart from employment participation showing that the economy is operating at full capacity, how’s our super hero going to continue his stimulative monetary stance for the benefit of all? 

He’ll do what every central banker does.  The Bank will focus on things that can justify the course that they want to take.  Don’t worry youth of the country, he will get you out of the basement.   Heck, it is apparent after the Governor’s last speech that he has already changed the Bank’s mandate by emphasizing employment over inflation.  It doesn’t sound like inflation running just above target is going to deter him from wanting to take us to a higher economic equilibrium.  His only problem is he has to justify it within the confines of the mandate that he signed on to with the government.  What to do, what to do?

I suspect the Bank will keep rates unchanged for a lot longer than would typically be the case with inflation at target and the economy at full capacity.  Pretending to adhere to the inflation targeting regime, communications will emphasize the slowing growth from measures previously taken and the continued uncertainty around trade.  They may have to move off of Nafta developments as that news risks getting better, but they can quickly shift, and rightfully so, to what is going on between Donny and Xi.  Add in the usual blah blah about Phillips curve flatness, competitive hurdles, expansion of potential through the push of demand on capacity constraints and you have a Bank that can continue to keep policy quite stimulative. 

Unless there is an unlikely uprising from any hawks in his posse that can change the Governor’s mind in their “decision-by-consensus” process, the foot will remain steady on the accelerator. 

   

Employment Targeting

I missed the announcement, but after reading the Governor’s speech on the labour market, it appears that the Bank of Canada has decided to adopt the Federal Reserve’s mandate of full employment, stable prices and low long term rates.  Remember when the Bank use to tell us it was only stable prices that mattered?  It appears the market now has to deal with a Central Bank that is primarily focused on a mandate of maximizing labour force participation that I don’t remember anyone giving them, relegating inflation to somewhere in the background. 

We are told that the economy is now in the sweet spot and by that I guess the Governor doesn’t mean that spot where the economy requires a ridiculous amount of monetary stimulus just to limp along at or under potential.  No, he is referring to when the economy is pressing up against capacity constraints requiring firms to either invest and/or hire if they want to expand their output further.  While a central bank totally focused on stable prices may start to calibrate their stimulus (ie. reduce) when this sweet spot is reached to get ahead of any budding price pressures, this speech suggested that monetary policy should continue to encourage demand to prompt further investment that can pull more people into the economy.  In fact, we are told that they have an OBLIGATION to allow it given the significant benefits that would accrue from an economy operating at a higher equilibrium. 

The speech takes us through a thought exercise where up to 500 k of additional workers could be drawn back into the labour market and employed, adding 1.5% to our potential output.  All that has to happen is youth participation rates in the labour market go back to pre crisis levels, women’s participation rates rise to Quebec’s levels, indigenous people sign on and recent immigrants get more quickly integrated.  Obviously that level of additional workers is not going to happen no matter how low rates go or how long they persist.  Many of the hurdles to labour market participation do not fall in the realm of monetary policy.  No, unfortunately, the hurdles exist as a result of political, educational, structural, cultural and generational factors.  How high those hurdles are ultimately determines the amount of slack there is left in the labour market.  My thought is that those hurdles are pretty high.   

People that are not participating in the labour market have their reasons, not all of them economic.  But if we believe in economics, the one thing that will bring some of them back is higher wages.  If this is not accompanied by investment that allows productivity to keep pace, history shows us what the consequences will be for inflation.  I find it odd that at the same time that the Bank is telling the market that investment is being negatively impacted by potential trade protectionist measures from Trump and his new buddy Larry that Governing Council is willing to risk that whatever level of investment does take place will be sufficient to raise productivity by enough to offset any wage inflation.   

Look, I believe that it is very public policy minded of the Bank to want to focus on wringing every last drop out of the labour market.  The harsh reality, however, is that is not the mandate they have been given.  As a market participant, the risks change when a central bank decides that its policy power should be used to maximize employment inclusion and put stable prices at risk, versus one that sets policy to keep inflation near their target and have the risks falling on employment.  To state the obvious, the interest rate path of a central bank that is content with its core inflation already near the target is a lot different than one that wants to test the bounds of labour participation.  The downside risks are also very different.  A steeper yield curve anyone?

    

    

Too Early to Tell

There really is not a lot to say following the Bank of Canada’s rate decision this week.  They did nothing and had plenty of reasons to remain inactive.  If anything, even with the economy at full employment, the odds of them being on the sidelines for a considerably longer period of time has risen.  It is going to take some time before they have a better read on the factors that influence inflation.  Their new favourite phrase in their inaugural economic progress report, given the day after their decision, was “too early to tell”.   Its too early to tell what is going on with housing following the measures taken by OSFI.  It is too early to tell the impact of slightly higher rates on credit growth.  It is too early to tell if inflation dynamics have changed.  It is too early to tell the extent of capacity being created as the economy operates close to full potential.  And, of course, we have to wait to see how badly investment is being impacted by the uncertainties surrounding trade and they can’t even quantify any adverse scenario with NAFTA until there are concrete outcomes.  

So it would seem it is too early to tell if another rate increase is imminently needed.  The economic momentum that was pushing rate increases has died for now.  Even after the Bank gets greater clarity and when this ship manages to get out of the doldrums, the extent of further hikes will be muted.  Rates will likely need to remain well below neutral (estimated by the Bank to lie somewhere between 2.5-3.5%) to offset the persistent competitive challenges for our exports, the impact of US tax reform and trade policies on domestic investment and given the unknown sensitivity of our leveraged economy to higher rates.  None of these factors are likely to change anytime soon.  Household credit is slowing but it is still moving higher.  Trump and his chumps Wilbur, Bob (can I call you Bob?) and Peter will continue to hang Nafta over our heads for as long as they are eating soup out of a can and our politicians at all levels seem to be in no hurry to address the vast array of things that are making our economy uncompetitive and in fact seem to want to add a few more.  

In the meantime, we will continue to accept weak political leadership and have the saver be burdened with the tax of lower rates and all other citizens who consume or use any imports pay the price of a lower currency.  Monetary policy should not have to do all the heavy lifting but it is the political expedient thing to do.     

US Trade Deficits: Brought to you by Campbell's Soup

The “easy to win” trade war has begun with an opening salvo on steel and aluminum.  Trusting his political instincts and putting faith in a few controversial advisors that view the cause and effects of trade deficits differently than most in the human race, Mr. Trump made the seismic move.   It’s unfortunate that in the real world the wrath of these measures, probably meant for China will be mostly felt by Canada.  Once again, we are the victim of a drive-by shooting.  I am sure that some in the White House told the president the facts, but when you are a genius you don’t have to listen.  Besides, his base will continue to think this is the first blow they wanted their government to make against their “job stealing” rival to the east.  

Up until a few hours ago, I held out hope that some of the adults in the room would temper the president’s intentions.  That is until I saw on television his Commerce Secretary Wilbur (Monty Burns) Ross out selling these measures to the base.  Wilbur did a little product placement by holding up a tin of Campbell soup that apparently he (or one of his staff) just bought from a convenience store for 99 cents.  Who cares if it goes up to $1.00?  Relax, everybody, this is no big deal.  

This, of course, begs the question to Wilbur as to how many cans of Campbell soup does it take to build a car or, since this is a national security priority, how many cans of soup to make a tank or a Stealth fighter.   

By the time this administration, that is blessed with an understanding of macroeconomics never seen before, gets through with the US, the only thing that most people in his base will be able to afford for dinner IS a can of Campbell Soup.  You can buy one from Wilbur.  

Anytime I hear the name Wilbur, it casts my mind back many years to a television show called Mr. Ed.  It was a sit-com about a horse who would talk and could be heard only by one person, Wilbur Post.  The humour was that the horse was smarter than poor Wilbur and would dish out advise and wisdom that would get Wilbur through the day.  I am not sure who the horse is for our current day Wilbur (but I do suspect its mane is orange) but I am sure that he has his ear up to the wrong end of the horse. We will all pay.