MPR: Is it just me that is confused?

The latest MPR was full of surprises.  Who knew that an over leveraged economy may respond more negatively to higher rates than an economy with less debt?  No sh*t Sherlock.   I wonder who created the incentive to get over leveraged?  According to the document, household debt, in fact, may be so important to consumption and residential investment that the Bank will now incorporate it into their main model.  May we all sleep better knowing this.

However, the real stunner for me was imbedded in the Governor’s opening remarks at the press conference.  He noted that given our recent history of inflation tracking below target, they continue to be more pre-occupied with downside risks to inflation.  As a result, the committee will be cautious in considering future interest rate adjustments and will be guided by incoming data.  This, of course, is the same bunch who gave you two quick hikes in succession over the summer while they were apparently pre-occupied with the downside risks to inflation.

The inconsistency of the Bank is mind blowing.  The distortions needed to be applied to their policy decision framework in order to be consistent with the narrative they want to convey would make a contortionist at Cirque du Soliel blush.  The Bank states in their opening remarks that they have confirmed their faith in their model of inflation, in which inflation depends on the degree of excess demand and excess supply-but operates with a lag.  Well although they go to some lengths in the MPR to convince the market that it is still relevant, as apparently digitalization and globalization impacts are not yet evident in the unexplained portion of inflation, their subsequent statements don’t align well with a central bank that truly believes it.  (To digress, and to paraphrase, I enjoyed it when they noted that globalization has lowered inflation in many advanced economies, but to date Canada does not appear to be an advanced economy.)  

Starting with the output gap closed, their outlook sees growth of 3.1%, 2.1% and 1.5% through 2017-2019, consistently above or at potential.  As currency effects wane, inflation gets back to target a year from now.  But given their professed framework, policy works with a lag, so a decision today will have an impact on inflation in 18 months or so, about six months after inflation has hit the target.  If they truly have faith in their framework and given this as their base case, it is difficult to justify suddenly becoming cautious.  If the framework is valid then their “cautiousness” implies a lack of faith in their forecast.

As has been done many times before by Central banks, they resort to moving the goal posts, tinkering with their decision making framework to justify inconsistent decisions.  They get “cute”.  In the past, this has meant changing in mid-stream the inflation rate they react to to achieve the target headline number.  First it was headline inflation less volatile food and energy, then it was something else and now in Canada it is not one, but rather three ,core rates that they can pick and choose from.  On another occasion, they did the old “switcheroo” by temporarily giving financial stability much more weight in their policy decisions than inflation.  It was suddenly okay to have inflation deviate from target for longer than previously thought acceptable.  Watch me pull a rabbit out of my hat.  This time it is suddenly revealing to the market that there is a difference between full employment and having the output gap closed.      

Since the GFC and through the oil price shock, the market consistently heard from the Bank that policy had to be extremely accommodative given the huge output gap, but that there would come a day when the output gap would close and that monetary policy would need to be tightened.  In theory, at the point of closing, the target rate should be around neutral, which this MPR tells us is around 3%.  And that day has come.  In this MPR, the Bank estimates that for all practical purposes the output gap closed in the third quarter of this year.   But wait a minute.  Just because they say it is probably closed doesn’t mean that it is closed.  No sir.   We are in the sweet spot now.  In a brilliant inversion of Say’s Law (which effectively states that the more men produce, the more they will purchase), we now are being told that demand creates its own capacity to supply almost instantaneously.   The opening statement tells us that every day our economy builds new capacity through new companies, through investment and by hiring.  By their reading the labour market is rife with slack.  I have no doubt that there are still too many teenagers in parents’ basements waiting for those management positions to become available.  Part timers can’t wait to sign on for longer hours and do their part for traffic congestion.  So according to the Bank, we really are not at full employment when the economy is back to a level of output consistent with its potential level.  But if so, this would seem to me to be more of an inherent structural issue with our economy, specifically the labour market and not something that can sustainably be addressed by monetary policy (but I digress).  

The large problem with telling the market that the supply curve is shifting out daily and offsetting any price pressures caused by the higher levels of aggregate demand is that it cannot be collaborated by the evidence.  The Governor, himself, admitted in the press conference that new business creation is disappointing and that business investment is not where it should be at this point of the cycle, weighed down by uncertainties around fiscal and trade policies south of the border.  Moreover, in this country, with all the regulatory and tax disincentives to set up businesses and invest, it is hard to believe that the aggregate supply curve can react as quickly as is being suggested.  

Canadian inflation, like its global counterparts, has been subdued for some time.  Wiser people say its low level is a “mystery”.  To say that you have continued to be pre-occupied with downside risks to inflation and will be cautious in considering future interest rate adjustments right after hiking twice in succession is audacious.  The only two factors that have really changed since we last saw our heroes raise the target rate is the optimism of reaching a NAFTA deal has been shaken and that the volume of those questioning the Phillips curve framework has become louder.  The slow down in growth from the first half was always expected by the Bank when they raised rates and in fact the deceleration so far is slightly less than anticipated and inflation is tracking slightly higher.  In terms of setting policy, the Nafta deal is a tail event and the Bank explicitly tell us that they still believe the output gap framework is valid.

In my years working at the Bank, there were times when I would be frustrated by the amount of spoon feeding that the market demanded.  We would always try to refer the market back to the framework that the Bank operated under.  Inflation targeting central bank, excess supply requires lower rates to put upward pressure on prices, excess demand needs higher rates to dampen inflation, blah, blah.  But this latest MPR will add to the confusion that the market already has with the current Bank regime.  The Bank’s actions and statements are not consistent with the framework they claim they are using.  If future policy actions are the result of “judgement” and are not consistent with what one would expect given the framework, the market is going to experience greater and unnecessary market volatility and ultimately the Bank is going to have a large credibility problem.  Manipulating the rules of the game (framework) and playing with semantics around full employment and a closed out put gap to suit the narrative that your gut tells you is right in a certain environment is not the right recipe for making policy. 

If a rules-based John Taylor doesn’t get the job at the Fed, maybe we could use him up here.        

Historical Yields and Inflation: the Next MPR

The always great FT Alphaville pointed out a recent working paper by the Bank of England that looks at eight centuries of the risk free rate.  (http://www.bankofengland.co.uk/research/Documents/workingpapers/2017/swp686.pdf)  The author builds a data set of the most relevant risk free rate in the world at a particular time, spanning the time period from 1273 to today.  

What does the data show?  Yields generally have ranged between 20% and 1.5% over the period examined.  There have been 9 bull markets in fixed income over that time period lasting anywhere from 10 to 68 years.  The average real yield since 1311 has been 4.78% and has averaged 2.55% over the last 200 years.  Current real rates are ridiculously low.  The author notes that at the end of 2016 the real rate of 0.81% falls short of the 95th percentile thresholds for lowest real rate across the entire data set.  Other fun facts include the absolute bottom in nominal rates occurred in this bull market with US 10 year bonds reaching a low yield of 1.37%.  The last time yields came anywhere close to that was in 1941 when the 10 year touched 1.97%.  As  well, the average length of a bull market on real rates is just short of 26 years.  At 34 years, this current bull market is the second longest.  

There is no doubt, that put into an historical context, nominal and real yields are extremely low.  The fundamentals and more recently the cajoling by central banks to fend off deflation have led to these outlier rates.  

However, what really struck me was the inflation data.  For the last 700 years, inflation has averaged 1.09% and over the last 200 years it has stood at 1.49%, the latter not being far from the current inflation readings in the US and Canada.  I know on their dating profiles our central banks like to take credit for anchoring inflationary expectations but this data would suggest expectations were anchored well before inflation targeting central banks came along. It’s unfortunate for the central banks that inflation may have a “natural” rate well below their 2% target.  You can’t get blood from a stone, so maybe, over the long run, you can’t get sustained inflation to the 2% target level.  No matter how much QE you do.  

As Keynes said, in the long run we are all dead.  So in the meantime we have to deal with central banks that believe they can turn the course of history.  We have to keep playing the game.  

In Canada, we are now “ultra” data dependent (whatever that means, versus being just data dependent).  We just got the inflation reading for September and it appears benign.  The Bank’s favourite measures of core, the three amigos, averaged 1.6%.  This would be .1% above the 200 year average but more significantly still below the Bank’s 2% target.  Although what matters is where the Bank thinks inflation will be in 18 months, the market reads that this will put the Bank on the sidelines on October 25.  Given that the folks on Wellington Avenue are now petrified that some market participants may yell at them again, the odds of the Bank doing nothing are higher than their output gap framework would suggest.  

More government, less hikes?

It’s hard to remain optimistic about Canada’s economy.  We have just posted the strongest growth in the industrialized world but it now looks like our elected officials want to snatch defeat from the jaws of victory.  For political reasons, governments seem to have shifted from ensuring economic growth to ensuring fairness.  After the great run of numbers we just had, most people would want to keep that momentum going.  Sometimes that may mean not rocking the boat and doing nothing.  Unfortunately the words “do nothing” are not in the vocabulary of our political elite unless you are talking about energy infrastructure projects.    

After the surge in growth that we have had, one would expect to see the numbers endogenously soften.  But in addition to this natural slowing, and in the name of helping the middle class, the domestic economy will be expected to shoulder a higher minimum wage in some provinces, a new tax on the small businesses, tighter regulations on non-insured mortgages, and fall-out from the Nafta negotiations that presently appear to be falling apart.  At this stage, it looks like all these measures will be hitting the economy around the same time.  This is on top of current regulations involving the environment that makes it virtually impossible to move forward on any infrastructure project.  Maybe the fact that we are at or near full employment gives the government some room to apply the fiscal and regulatory brakes, but for much of their agenda, they have no clue as to the ultimate impact their new policies will have on the economy, either directly or indirectly.  Consultations that were held with stakeholders on the wage hike, the new tax regime and the mortgage revamp were pretty clear that the first and second round economic consequences may be more negative than expected and there was concern voiced about unintended consequences.  Unfortunately the experts’ concerns fell on deaf ears as both the government and OFSI seem determined to forge ahead with a few possible minor tweaks.  These folks that voiced the possible negative effects obviously had vested interests in the status quo.  You can’t fool our political elite who refuse to let facts get in the way of a good political story.  

So with the governments determined to “rain” on the economic parade (and we haven’t even mentioned present and future hydro rates in the most populated province), how is the central bank suppose to incorporate these measures into their forecast of aggregate demand and longer-term potential growth at the upcoming MPR?  

For the most part, they won’t.  Unless it has been announced as official policy and estimates have been produced by the respective governments as to their impact on the economy and their deficits well before October 25, these overhanging items will not be addressed in the outlook.  This means that the impact of the hikes to minimum wages will be imbedded in the forecast, but nothing else.   

The Bank may make mention about these potential measures in the risks to the inflation outlook, but I doubt it.

Something to keep in mind when we get to look at the economic growth outlook produced for the upcoming MPR and start conjuring up a profile for the target interest rate.   

Central Bank Communication

For Central Bank geeks, last week was eventful.  The head of both the Federal Reserve and the Bank of Canada took to the podium to explain to the market that they have shifted into “grope” mode.  Both institutions have moved well past the point when appropriate policy was obvious which has generally been the case since 2008.   The huge output gap that opened up in the two countries following the financial crisis required nothing but various degrees of ridiculously accommodative monetary policy.  But now, by historical standards, the two economies are at or near full employment.  The only problem is that inflation has not yet responded as one would expect with the gap closed.  This potentially throws the whole Phillips curve framework that the two banks predominately use for policy determination into question.  The confidence that they once held in this framework is being tested.  In this scenario, it is not surprising that they would shift into “grope” mode as the clarity of the environment they are operating in has become murkier.

This new environment is likely to create a gap between what the market has come to expect from central bank communication and what the central bank can provide.  The level of confidence that the proper policy was in place when it was extremely obvious what policy was needed allowed and even forced the central banks to be extremely transparent and explicit.  In the height of the crisis, it gave birth to the idea of forward guidance where central banks promised to keep rates locked at low levels for specific periods of time or until certain economic criteria had been met.  The market was effectively spoon-fed what to expect when it came to rates so there was no reason for the markets to scrutinize the economic data.  The central bank would do the analysis and then tell the market what was next.  

So this week both central banks were very transparent.  From the speeches, the market heard the Fed say that interest rate increases will continue at a slow pace.  On the other side of the border, the market heard the Bank of Canada put a damper on rate hike expectations apparently to ground the high flying loonie.  But I am not sure the market truly heard the subtleties of what was said.  No doubt the market properly interpreted the most likely interest rate path for both countries but I don’t know if they appreciate that the central banks have much less confidence in the interest rate profile that they are suggesting.   Moreover, given that markets are backward looking, the last ten years would suggest the markets’ portfolio of interest rate profiles is likely biased to the downside.  At the same time, a central bank is suppose to be forward looking which would suggest a set of unbiased rate profiles that will allow them to hit their inflation target that has a greater uncertainty band around it.  This means their menu likely includes profiles where rates could go up much quicker than expected by the market but also includes scenarios where they could just as easily go down.  It will depend on the data!    

After almost ten years of being central bank dependent and not data dependent for front end rate determination, it is not surprising to me that the market is struggling a bit with a central bank that can no longer give them the precision that they crave.  It is unrealistic for a central bank to give the market guidance suggesting one interest rate path, when they are less sure of what the appropriate policy is themselves.  As the confidence bands expand around their forecast for inflation, the number of appropriate possible interest rate paths multiply. 

What's he going to say?

The market is breathlessly awaiting to hear from the Governor this week to get a better read of where he stands with respect to policy now that the Bank has moved twice on interest rates and seen the currency appreciate significantly.   After Deputy Governor Lane stunned his prairie audience with a post-speech remark that the Bank would be watching the currency closely post its recent run, I suspect the market will pounce on any glancing comment the Governor makes about CAD. 

As a trader, I get it.  As someone trying to get a grip on future policy decisions, what the currency does over a minute, an hour, a day, a week or even a month is just not that important.   Why is that?  These are periods of time that are too short to have an impact on real growth.  One only has to read Lane’s speech to get an understanding of the number of things other than CAD/US that impact trade over the policy time period that the Bank really cares about.  Not to mention that the exchange rate has implications across the economy not just on trade.  Stronger Canadian dollar..bad for exports (maybe) but good for capital investment (maybe), the two things that the Bank said they would be watching carefully when determining future policy.  

To exaggerate, the market believes that at 1.28, the Bank is content but at 1.22  they are concerned.  The point is that they will only be concerned a quarter to two from now when they have sufficient economic data to tell them that they should have been concerned now.   As Lane said in his speech, but maybe did not emphasize in the Q&A, they will watch how the economy responds to higher rates and a stronger dollar.  They will not base policy on how some people think the economy will respond.  I am not convinced that they have seen enough evidence yet of the impact of this year’s appreciation of the loony on the economy.  They will be watching the data closely (as they always do) as it unfolds over the coming months and their target interest rate will be calibrated to account for the impact sometime in mid 2018, if necessary, to get the economy to glide back down to potential.  

My final observation, again to be found in Lane’s speech, is the graph depicting their new measure of the Canadian effective exchange rate (CEER).   This new measure includes a broader set of countries and accounts for both bilateral trade with another country and the competition Canada faces from other countries that trade in the same good with that country.  So its not just how competitive the going level of CADUS makes us in the US, but also how competitive the peso is making Mexico, for instance, when an importer in America is looking at his/her options.  From a historical perspective, what does the graph going back to 2000 show us?  This new index has traded in a range between 95 and 140.  In the early 2000s, CAD was too weak which led to the creation of a fragile export sector, one that was not based on real economic fundamentals and collapsed quickly when the currency appreciated.  Then just prior to the crisis, the currency was responding to a surge in energy prices and was too strong which resulted in the gutting of even some very competitive firms.  

If history is a guide then, the takeaway is that the index at 95 obviously represents a level that is too weak and at 140 it is obviously too strong.  We are currently sitting just above 120.  It is above the mid point but I wouldn’t want to say that it is in the red zone quite yet. 

What is the Gov going to say?  My bet is that it will be the usual.  He will repeat what was in Lane’s speech, not what was said over coffee.

Off the wall thoughts on the Fed

We are heading into an eventful Fed meeting this week.  The market appears poised for the commencement of the long awaited shrinking of the Fed’s balance sheet.  The prevailing wisdom is the slow unwind of their holdings will not pressure yields higher.   If you are an equity analyst you have priced in that it will never have an impact on yields and if you are involved in credit, you may expect some small effect much later.  So despite the view that there will be little to no impact on yields from this action, the market also seems to be saying to the Fed that a rate hike should not be contemplated in conjunction with the introduction of balance sheet reduction.  

By strictly focusing on inflation readings, I understand why the market does not think a rate hike is needed this week.  But don’t use the new diet of the Fed as an excuse for them not to raise rates if you truly believe this balance sheet action will not have any impact.

This brings me back to focusing on inflation readings.  When it comes to fulfilling the mandates that are given to central banks by their respective elected governments, one could argue that the Fed is closest to ticking off all the boxes and should be the one acting in a relatively more aggressive manner to get rates back to neutral.  Way back when, Congress mandated the Fed to maximize employment, stabilize prices and try to achieve moderate long term interest rates.   With unemployment sub 4.5%, the PCE deflator stubbornly too stable at under 2% and the ten year bond yielding just over 2%, it looks like the overall mandate has already been achieved. 

Unfortunately nothing is that simple.  In 2012, the Fed issued a statement describing its strategy to best achieve the three objectives laid out by Congress.  In it, they stated that their focus would be to achieve and stabilize their favourite measure of inflation around 2%.  If this was met, the other two would fall into place.  

This 2012 statement has the market and, it seems, the Fed preoccupied by the strategy objective of achieving 2% inflation rather than on Congresses’ overall mandate.  This leads all involved to want monetary policy to remain very accommodative in order to nudge inflation slightly higher to attain the arbitrarily chosen 2% target.  But, is there a risk, with inflationary expectations anchored below their target level, that policy starts pushing the other two objectives of the Fed’s mandate away from their optimal levels?   

The most likely case is that we will find out.  The lower probability case is that the Fed starts to recognize that the job they have been given is largely complete and it is time to pick up the pace and get ready to rearm for the next recession.  

Surprise....Again

It has been a while since I wrote a blog.   As the summer began, it looked like the Bank would  duly take back the 50 bp in cuts that it initiated in early 2015 following the oil price shock.  The market was pricing in an increase in July and then again in October.  Following those two moves, many thought the Bank would then be frozen until God knows when.  

Well the market got the July call correct but they underestimated Mr. Poloz’s ability to surprise in September.  A move taken without the publication of the Monetary Policy Review to explain and describe why the action was taken was apparently just too difficult for half of the market to conjure.  Although the initial cut back in January a few years ago was an “out of the blue” surprise, an equally surprising increase was apparently unacceptable.  I am not sure who didn’t learn a lesson from the previous episode, the Bank or the market? 

Some in the market complained that the Bank did not give the market a heads up.  As a result, the price action in the rates and currency market were deemed to be unnecessarily volatile following the decision.  I suppose a wink and a nudge here and there would have prevented people from losing money or losing face.  This forced the Bank to come out and defend themselves for acting without communicating to the market ahead of time its intension to raise rates, saying there normally are no speeches over the dead of summer and the very strong GDP report came out during the black out period.    

Those that complained should be ashamed.  Many need to put their big boy (or girl) pants on.  The July MPR told us that the output gap would likely be closed by the end of this year and the press release told us that the Bank believed that low inflation was temporary and, most importantly, that future adjustments to the target rate would be guided by incoming data.  As we know, that incoming data came in extremely strong, with GDP growth well over 3%, well above what the Bank was expecting and almost twice the pace of the lower band of estimated potential growth!  Bottom line, the output gap, if not already closed now is a breath away, not three months from now as estimated before and the economy still has momentum.  

Market economists have the technology.  They saw the numbers at the same time as the Bank and had the same amount of time to pull out their calculators and do their analysis based on what the Bank had told them just five weeks earlier.  

To be fair, I am sure that many looked at the numbers and concluded that the Bank had good reason to go in September, but immediately started looking for reasons why they wouldn’t given where inflation is tracking.   Current inflation remains well below target so why the rush? 

The rush is that the Bank is targeting inflation two years from now.  As long as they continue to believe in the Phillips curve framework (which the September moves tells us they do), today’s low inflation rate does not get the weight in the decision process that the market continues to believe it does.  For the Bank, what gets more weight is that the output gap is virtually closed now and while growth looks like it will slow, it will continue to track above potential, putting the economy in an excess demand situation early in the New Year.  

Being generous and assuming that the real neutral rate is zero and that inflation remains around current core, this suggests that the Bank would probably like to see a nominal target rate of around 1.5-1.75% at a minimum by early in the new year. 

This shift to higher rates is necessary to glide inflation to its target but it seems like it could be traumatic for market participants.  The Bank will have to hold the market’s hand or maybe even drag it along, but that is where we are headed.  If we can’t get rates closer to neutral now given solid domestic and foreign growth, when will any central bank ever be able to?