A Wynne-ing Strategy?

Recently in a church basement in downtown Toronto….

“Hello, my name is Ontario and I am a speculative bubble.” 

“Welcome Ontario.  My name is Kathleen.  I take it that this is your first time to one of our meetings?  We are heartened that you have recognized that you have a problem and that you would like to do something about it.  That truly is the biggest step.  Please relax.  I know this is suppose to be anonymous but you may recognize some familiar faces in the group from Australia, Asia and some cities in Europe.”

“Most of the people here are already familiar with many aspects of our 16 step program but let me just run over the basics for you.  The good news is that our program is painless.  The biggest step is the imposition of a property transfer tax of 15% on non-citizens and on those who are not permanent residents of Canada.  Vancouver, sitting in the back over there, went through the same thing and there was just some temporary mild discomfort.  For you, Ontario, they tell us that this will have even a smaller impact on you as about only 8% of buyers fall into this category.”  

“For pain management, we are imposing the tax only around the Golden Horseshoe.  Maybe this will push some of the speculative buying up to The Nation’s Capital.   If federal policy makers start seeing their home prices go up, maybe they won’t be so grumpy and envious…I’m just kidding.”

“The other big part of our program is that we will be implementing rent controls, keeping them at the rate of inflation with a cap at 2.5%.  Again, this should be relatively painless for you.  We were just trying to stop some people from using your state to take advantage of others.”  

“One last big thing. We want to put in place a vacancy tax once we figure out what that means.  Any questions?”

“You are not going to do anything about domestically-driven speculative activity?”

“Nope.  Those buyers will probably back off for a few weeks until they get a feel for how important the foreign buyer was to the price increases, but I’m sure fundamentals will reassert themselves in no time.”

“You are not going to do anything about new housing supply?”

“Well, we are doing something.  The Government had some acreage that they weren’t using so we will construct some low income housing.  It’s not that those people were driving the speculative frenzy, but it does look good.”

“What about the greenbelt around Toronto?  People tell me if restrictions were changed that could deliver significant amounts of new housing.”    

“Our program is designed to be painless for both our voters and the environment.  If we released too much supply, prices could come down too quickly.  We don’t want to hurt the boomers by risking their hard-earned housing lotto winnings.”

“And nothing is going to be done about interest rates?  I don’t have to suffer withdrawal from mortgage rates moving higher?”

“Well now that you have joined our program, that is all the Bank of Canada wanted to see.  They can wipe their hands clean now.  Now that you are a card-carrying member of regions carrying out macro-prudential measures against speculative activity, or MPMASA, they could even lower rates if they felt they had to once Mr. Trump milks NAFTA of its anti-American biases.   Doctor Poloz up in Ottawa has done some fascinating work recently on the subject, claiming that interest rates have no impact whatsoever on what is happening to home prices in your region.  It really is ground-breaking stuff.”

“Okay, so let me get this straight.  This program will help address my speculative sickness by directly attacking 8% of the problem and by indirectly tinkering on the edges of some other things.  I may have some very temporary side effects but they will probably subside in a month or so and now that I am carrying a membership card to MPMASA, this frees the central bank up to cut rates and give me a quick boost if they feel it is necessary because Poloz doesn’t think interest rates had anything to do with my predicament in the first place.”

“Yep.”

“I’m in.”

Unemployment: Poloz's Final Frontier

Let me be one of the first to welcome Captain Poloz and his spacecraft the HMS BoC back to reality from their recent intra galactic voyage.   The Bank’s latest version of the MPR seems to be more in tune with our world.  They finally acknowledged a number of data points that had been read by us earthlings as actually occurring but until this week appeared to be largely ignored by our monetary masters.  Don’t get me wrong, they are still claiming some economic relationships that may work only in zero gravity, but overall they have touched down, however briefly, and joined us in reality.

First, let’s look at their log book that recorded observations when the ship’s wheels hit the tarmac.  They acknowledged that growth had come in much stronger than they were expecting when they left in January.  The oil and gas sector getting up off its knees, strong demand for autos and, of course, an out of control housing market contributed to a surge in activity.  First quarter growth is now strong enough to give the Governing Council enough fortitude to say that interest rate cuts are now off the table.  The Governor during the press conference even said that the recent economic data was good news.  Now if he would only look like he meant it.  

Once they landed they also noted the housing market in the GTA and, given their reading off their price increase meter located on the bridge, concluded that there may be some speculation going on in the region.   They went as far as to include the housing market as a near term positive risk to inflation and to admit that it could also potentially create a macro and financial vulnerability in the future.   

Alas, this was all too much good news for them.  After admitting that economy is in a better place, they quickly reverted to their suck and blow approach to keeping financial conditions accommodative.  Before anyone should get excited about the possibility of increased rates or a stronger dollar as a result of a higher starting position, they stressed that they believe that the recent surge in growth and inflation are just temporary.  From now on, everything is down hill.   The material excess capacity in the economy will be slow to absorb and until every young adult leaves their parents’ basement and finds gainful employment you will have Captain Poloz keeping the shields up and continuing to demand lasers be targeted at non energy exports and be set on accommodation.  GC concluded, after pulling a new rabbit out of their hat with respect to potential growth, that the output gap will not close until the first half of 2018, ever so slightly sooner than envisioned in January.  Their message: Everybody calm down and buckle up in preparation for serial disappointment.  

Confusingly for us, when they create a narrative, they continue to defer to the economics text book they picked up while visiting Uranus University (known as U2 to the alum) on the transmission of monetary policy in zero gravity.  Economic relationships that apparently are theoretically robust in space, but don’t seem to be consistent with what most of us on earth deem to be reality.  According to profs at UU, interest rates have no impact on the housing market (or colonies).  Hell, as the Governor told us several times, rates could go to 5% and still not have an impact.  Those darn speculators are immune.  I remember in economics classes taken on earth, we were always taught that as a result of leverage, the housing market was one of the most interest rate sensitive sectors.  As a result, I am still going to believe an increase in rates would have some impact in cooling the housing market.  But again, a different world.  

More fascinating in zero gravity is that changes in interest rates apparently can have very concentrated effects. In space, changes in rates have no impact on housing investment but do leave an impression on other components of growth, including business investment.  The MPR tells us that the only sources of growth we have to look forward to in the near term will be household spending which will be supported by accommodative monetary policy (except, I guess, for anything to do with housing which is unresponsive to rates) and fiscal stimulus.  The next time GC departs into space, I hope further work will be done studying the elasticity of certain sectors to changes in rates.  Maybe try to understand why in space, rates can rise by 5% and have no impact on a bubbling housing market while at the same time business investment, which we are told is partially paralyzed by uncertainty around US trade measures, is hyper sensitive to the downside given even the slightest hint of a rate increase. On this planet, it wouldn’t matter to business investment if rates went higher.  It would be like stabbing two day old road kill.  

And while the crew is up there, they should track down the financial market literature on the role of “chunks” in dampening financial asset bubbles.   Even without gravity apparently some things can still go down.  The theory apparently states that since the speculator has to buy the entire house,  as prices go ever higher he/she will be unable to muster up sufficient funds to either buy a house or find a buyer who has the financing for the house he/she is trying to flip.  The market then falls under its own weight.  On earth what we are seeing as prices are going through the roof are speculators banding together and splitting any profits.  What we have is the price (known in space as “chunk”) divided by however many speculators want to be involved.  Suddenly the chunks are small again.  Heck, in the 905 region around Toronto, families are combining their incomes to buy one home to live in permanently together.  Having said this, it would be great to get a hold of the work done so we can be better prepared.  The last thing we all want to see is a market blowing out chunks.

The Governor concluded the MPR saying that they are now decidedly neutral.  The market seemed to view the acknowledgement of the stronger data as slightly hawkish.  With the captain of the spaceship convinced that there is excess capacity, and emboldened by low readings of core inflation, economic theories taken from both our world and from their travels will be used to create a narrative to justify extremely accommodative policy.  This is a captain a few years into his seven year mission who is nobly focussed on getting as many people working as he can before the asset bubbles he has created come crashing down on top of him.  He is going where no man sitting in his chair has gone before—unemployment below its natural rate (NAIRU).

Don't blame me

Just when I think I have heard it all….The Governor was asked by Macleans magazine if his institution bears any responsibility for the ongoing speculation in the housing market?  

His answer was an emphatic NO.  Apparently when housing prices are expected to increase dramatically, the level of rates that people would borrow to finance their investment becomes irrelevant.   I would think that higher rates might act to reduce the available leverage to a prospective speculator based on income but I don’t have a Phd.  No, the answer was clear.  “It’s not low interest rates that are fuelling speculation.”

No siree, Bob.  And for the record, it’s not alcohol that fuels intoxication.  

Meanwhile...the economy keeps growing

The sun was out and there was a definite hint of spring in the air.  I was feeling pretty good and optimistic about life after coming in from a walk. Then I flipped open my laptop and listened to the Governor’s press conference following his speech in Oshawa.  Wow.  What a downer this guy is becoming and, to boot, he is getting a bit testy when asked about his cautious tone.  It must be frustrating when the mere mortals that make up the economy do not understand the grave danger this economy is in at the present time.   

In brief, there is no change in the Bank’s very dovish view.  The Governor would not even rule out the possibility of rate cuts despite seeing the same positive economic news as the rest of us.  He even told us that a return to normal rates at this point would cause a recession,  although no one I know has suggested that he rapidly push up rates.  

He reminded us all that the Monetary Policy Report is coming out in a few weeks and he will give us his updated assessment then.  However, I would wager that a few weeks are not going to materially change his bias.  Any stronger growth will have reduced excess capacity but it will not have closed the gap.  Against that backdrop, the Governor will stress that core inflation stubbornly remains below target.  Most importantly, the elephant in the room has not left.  It is unlikely that there will be any greater clarity around the timing and specifics of possible US protectionist measures between now and then.

So apart from the Bank being downbeat and remaining dovish, what else did we learn in the press conference and speech? 

We received a concise history of the Canadian economy that highlighted the importance of trade to the country.   

The Governor explained to us that the negative impact from any protectionist’s measures is ridiculously difficult to quantify as behavioural changes and linkages at the micro and macro level are just too complex.  We now know that certain types of increases in protectionism can be modelled, but the degree of uncertainty around the outcome is huge, as in Donald Trump “huge”.   So the potential for a very large negative outcome exists.  The Governor could be uttering a Draghi-like “whatever it takes” to a business audience soon (or not).  

The Governor revealed his thoughts on housing prices.  Apparently, the Bank’s concerns and the actions of various federal government agencies have never been directed at affordability, slowing down the increase in housing prices.  Those nasty increases in the GTA have come about from simple demand/supply dynamics specific to the area.  Strong economic growth in the Toronto region, coupled with immigration are just too much for the available supply.  The Governor did say that there may be some expectational (speculative) buying starting to appear, but that will be monitored.  I am not sure why.  After all, there is nothing the Bank nor OFSI nor DoF can do about that.  Nope, their focus has been on creating the firewall that will ensure that if residential home prices fall, any negative feedback to the financial system will be contained.  When analysts or the media look at ever rising housing prices in the GTA and then conclude the measures taken to date have been ineffective, they are using the wrong metric.  The new rules are helping ensure that the lenders and the borrowers are in a better position to absorb any shock.  As long as stupid prices are not being financed by our financial system, but rather by the bank of mom and/or dad or foreigners, then there is little risk to the economy associated with stupid prices correcting.

  

I continue to struggle with the idea that there is zero risk that a sharp decline in housing prices for a third of the Canadian population will have no negative impact on economic activity and hence on inflation.  The amount of economic resources that have been attracted to housing related activity, let alone any notion of a wealth effect influencing spending do not appear relevant for the Bank’s outlook. Maybe Canada will be “lucky” as the US was in the tech crash of 2000 where the economic fall out of the NASDAQ’s melt down was limited and contained.  But I would point out that monetary policy actions were taken following that crash to clean up.    

What I will take from the Governor’s comments on the housing market is that he remains determined to keep it a financial stability issue and out of monetary policy deliberations.  At the upcoming April meeting, given the risk management framework used when setting policy, they will discuss how much risk weighting they should give to potential US trade measures negatively impacting inflation over the forecast horizon. They will try to quantify something that may or may not happen at some point in the future, neither knowing if protectionist measures will ever be reality, their extent nor the magnitude of any negative impact even if they are implemented.  At the same meeting, there will be no discussion of any possible impact to the economy from a housing price correction in the GTA, a risk that is currently based in reality and building daily, in part driven from “expectational” buying.

So looking at these risks, what most likely comes first?  Sufficient clarity on US trade policy or a correction in housing prices in the GTA?     

   

Housing Bubble? What housing bubble

This week the Bank of Canada had the opportunity to revise its dovish message via a speech given by Deputy Governor Shembri on business investment.   They chose not to budge.  They continued to downplay any recent positive global and domestic economic data, focusing instead on the large difference in the size of the Canadian output gap versus that of our southern neighbour. The Bank remains highly skeptical that Canada “is out of the woods yet”. Too many false starts over the last few years (“serial disappointments”)have obviously scarred Governing Council and has them concerned that the rug will be pulled out from underneath them again.   

Like Bambi staring at the oncoming car lights, the Bank appears frozen, transfixed on geopolitical risks that may include protectionist measures taken against our exports by the new Trump administration sometime in the future.  I am sure their anxiety has even been amped up further following the US refusal to refute protectionism at the recent G-20 meeting, and given hints that the administration is preparing to soon issue the 90 day notice of their intension to revise NAFTA.   

In the meantime, the economy keeps marching on, apparently having found its footings.  The speech mentioned that the worse may be behind the energy sector, that government stimulus will lend support, and that the service side of the economy will contribute to any expansion.  Growth now seems likely to exceed what was outlined in the January MPR when they saw growth at over 2% in 2017 and 2018, above their estimate of potential in both years. 

While the economy moves forward, roughly one third of the population remains subjected to a housing market that refuses to cool.   Any macro prudential measures that have been taken by the federal government and its agencies to date have not been effective.  Recent comments by the Minister of Finance suggest a reluctance to impose more restrictive federal policies on the entire country when it is just a few isolated areas in the country that are experiencing the bubble in prices.  Apparently the fiscal tools at the government’s disposal are just too blunt….so over to you at the provincial level.  Yes, you.  The one with a 12% approval rating.     

The Governor will tell anyone who listens that monetary policy decisions are made within a risk management framework.  His dovish leanings would suggest that he is convinced the economy is operating with significant excess slack and so the downside risk to inflation of a geopolitical event slamming our exports is greater than any significant upside risk to inflation from a stronger than expected economy.  The recently published inflation numbers probably embolden this view for now.  But timing is involved.  The longer it takes to get greater clarity around trade, the more time the economy has to close the output gap and the calculus changes.  At some point, he may have to increase rates, forcing him to later save the exporting community by cutting rates from a higher starting point.  

In the meantime, what harm is there in keeping rates exceptionally low and keeping downward pressure on the currency? It is an easy decision when you put zero weight on the risk of a housing price collapse impacting inflation.  Maybe Governing Council attended the recent Tony Robbins and Pit Bull real estate conference held in Toronto where folks were assured prices can only go up.  Whatever their reasons, in the speech where the Bank outlines the upside and downside risks to inflation, there is no mention of what is going on in that sector.  Why would they (I ask sarcastically)?  I understand that normally the housing market is supported and is vulnerable to the underlying economy.  Their own stress tests show how devastating a loss of employment would be to this sector.  I get it. But with each passing day, housing prices get further away from justifiable levels, having parted ways with the macroeconomic fundamentals that have traditionally explained movements in housing prices.  When asset prices become warped, does causality remain one-way?  I personally find it hard to believe that there is zero risk that a collapse in housing prices, impacting a third of the population will have no impact on the overall economy and, hence, inflation.  I would have thought that is one lesson policy makers would have taken away from the US housing fiasco.  But no, in Ottawa this remains a vulnerability to be discussed only in the Financial System Review.  In other words, it is no doubt a concern, but in their view, certainly not anything that can be addressed with monetary policy.  Better to clean up the mess afterwards than lean into it now with higher rates.  (Again, sarcasm.)The interest rate tool is just too blunt of an instrument ( and where have I heard that before).  Apparently, implicit in the Bank’s actions, with inflationary expectations well anchored, this tool should only be used to keep pressure on the currency to support non-energy exports.

  

Bank of Canada: Financial Conditions too tight...really?

The Bank of Canada left interest rates unchanged this week and opted to remain dovish by highlighting the material excess capacity in the economy, the competitive issues with our exporters and by reiterating the significant uncertainties that could negatively impact the outlook.  Interestingly, they also made mention of the currency and yield levels again, saying they had remained near the levels seen at the last update.  The Governor expressed his unhappiness with these levels in January and apparently is still frustrated, believing they are at levels inconsistent with getting inflation back to target in a timely manner.

Subsequent to the press release, Canadian GDP for the fourth quarter of 2016 was released and came out above the market’s expectations and the Bank’s outlook, with quarterly growth of 2.6% annualized.  Given the Bank’s focus on the diverging economies between Canada and the US, I cannot resist pointing out that his compared to growth south of the border in the same quarter of 1.9%.  Post the release, analysts seem to be divided whether the number exaggerated the underlying strength.   Detractors focused in on the deceleration in domestic demand, while optimists pointed to business investment, the main culprit of the decline in domestic demand, as masking firmness in the other components of output. 

What cannot be said from the numbers is that the level of interest rates is not sufficiently low enough to drive the household sector to spend.  Growth for this sector was concentrated in interest rate sensitive sectors like housing and cars.  Moreover, these yields that may be considered “too high” are an important factor behind a large swath of the population seeing housing prices soar.  Recently released data show an average single detached home in the GTA is now selling for over $1.2 million, an increase of 28% over the last year, and this is spreading as prices in the 905 region increased 35% over the same period.  

However, with respect to business investment, yields and the dollar are obviously not low enough to offset all the costs imposed by competitive disadvantages in this country including regulatory hurdles, environmental studies and uncertainties around the future economic landscape.  Business investment remains very weak and it is doubtful that slightly lower yields and a lower currency would be enough to finally ignite a dramatic reversal in this sector.  The answer to spur more business investment may ultimately lie more on the regulatory and fiscal side. (Watch US economy for further details and results.)

Out of curiosity, it would be interesting to know from the Bank’s models where yields and the currency would need to be before the Governor stopped giving them an honourable mention, when he would consider them to be in sync with getting inflation back to target in a reasonable timeframe.  It would also be interesting to know the size of any reaction to housing prices from the increased incentives to both domestic and foreign buyers.  Unfortunately, I doubt their models include that reality.   

  

Monetary Policy and Housing: Part 2

I was invited the other day to hear a chief economist of one of our major banks give his assessment of the Canadian economy.  The presentation was being given to an audience made up of their retail customers in the Greater Toronto Area.  After giving a thorough talk on everything in Europe, China, the US, which included a large section on Trump and his outlook for Canada, he opened it up for discussion.  It quickly became apparent that all the retail base wanted to hear more on was the housing market in Canada, not more on Trump.  It was all about the housing market, when they should sell, or if they were ever going to be able to buy.  In retrospect, it was not surprising that this was the focus following the presentation as it was also the topic du jour over a glass of wine ahead of the event.  I admit I was taken aback with the amount of emotion surrounding this topic. Bubble anyone? 

Now given that I have a post graduate degree in economics, sadly I guess that makes me an economist.  And according to many central bankers, economists are unable to tell if a particular asset class is experiencing a bubble.  Given no change in aggregate economic fundamentals, but watching housing prices soar relentlessly from a market that clears through frantic bidding wars apparently is no basis to conclude that the market is in a bubble.  This is merely the price that is required to clear a market starved of supply when you have many readied buyers armed with ample credit.  Thank goodness it’s not a bubble.  Because if it was a bubble, the prescription written by the same economists who can’t recognize one is to do nothing.  For them, it is better to remain a Bambi, stay motionless in the lights and then clean up the mess if/when there is an explosion.  This is based on the premise that the potential cost of any clean up to the economy following the bubble popping will be less than the cost imposed by reducing economic activity through higher rates targeted to dampen any perceived bubble. 

This seems to be a hard argument to swallow after the cost we saw imposed on the global economy of a clean up strategy following the housing calamity in the US in 2008.  Unfortunately, we will never know the cost to the economy of what a firmer policy in 2006-7 would have been to make a comparison.  So with no data to refute this chosen protocol, all a central banker can do is stick to the protocol.   The Bank of Canada, by publicly deflecting responsibility of responding to the housing situation to the politicians, is sticking to the central bank handbook and is setting itself up to be Molly Maid if and when the time comes.

However, the results of following the protocol depends on the starting point. If a central bank is limited in its firepower to add stimulus when the blow up occurs, the cost of any clean up risks being larger than if the monetary authorities start with a full chamber, as the recovery will likely be more protracted.   In the current Canadian context, with rates near zero and deficit spending already reducing fiscal capacity, the risk of a long costly clean up rises appreciably.  Policy makers need to acknowledge that the calculus is changing.  With housing prices in a economic significant area of the country increasing by the day, the expected potential cost of any clean up strategy will soon rival any estimated cost to the economy from accepting an inflation rate being below its target for a longer period of time.  

It’s time for the Bank of Canada to be responsible and accountable for the impact of their monetary policy, bubbles and all.  This will require the inclusion of asset price behaviour into their monetary policy decisions and the acceptance that hitting an inflation target in a reasonable period of time at all costs may turn out to be too costly.