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.   

Sari about Fiscal Policy

Freshly back from his foray on the runways during fashion week in India, our PM returned and had his pal Finnegan table his government’s budget. (Can’t wait to see what JT, Sophie and the kids will be wearing when they visit the San people in South Africa).  Not surprisingly, it turned out to be more of a political document rather than an economic blue print needed to address the challenges that confront Canada.    

Over the last half of year, headwinds to economic growth in this country have stiffened.  Growth has dropped from well over 3% in the first half of 2017 to bump along around 2% at best.  There is little that the government can do about the damage to investment being caused by an erratic Trump and what he may or may not do with Nafta but there are many things that have negatively impacted the competitiveness of our economy that have been self inflicted that could have been acknowledged.  Apart from the seismic shift in international competitiveness resulting from American tax reform, recent domestic policy changes have excessively burdened our industries.  As one person noted to me, there is no sense that Canadian politicians have the “back” of business.  There is no thought of where the money comes from that these toads like to spread around in their party’s name.  From dramatically raising minimum wage to consistently throwing more regulation and environmental studies at projects, there is a sense of fatigue. 

This budget reminded me that the notion recently brought forward by the Bank that they could work in a coordinated and ex-ante way with the government to address consistent inflationary or deflationary forces is fantasy.   The government would have the Bank’s back only if it was viewed by the government in power as politically expedient.  Right now gender issues are more important than showing leadership to end interprovincial spats that keep Canadian produced oil prices depressed;  more important than keeping our overall business taxes competitive; more important than facilitating critical infrastructure in a timely manner; and more important than readying the overall fiscal situation to be prepared for the next downturn.

So all this leaves monetary policy as the only game in town to offset these challenges.  Rates will be lower longer and the currency weaker than would be the case if Mr. Dressup and his government had a different agenda.  With C+I+(X-M) sagging and no change in G (no Justin that does not mean Gucci) look for the Bank to do what it does best for a while….absolutely nothing.   

Bring in the Clowns?

At the end of the last week, one of the Bank’s Deputy Governor spoke in Winnipeg on the benefits of well anchored inflation expectations and how inflation targeting has been a major contributor to anchoring these expectations.  

He explained the issues and challenges ahead for the central bank as they start the process of renewing the inflation target agreement between the Bank and the Department of Finance for 2021.  Very candidly, he spoke of the declining trend growth of developed economies and the dampening of cyclical recoveries that could be expected.  While greater stimulus will be needed to offset these structural changes in the next downturn, he admitted that the amount of firepower that central banks have at their disposal is declining.  Less space in G7 countries for borrowing to stimulate demand due to the overhang of debt resulting from the 2008 “fix” and a declining neutral rate will constrain the effectiveness of monetary policy in the next downturn.  As a result, optimal macro policy would now demand more coordination of fiscal and monetary policy.   Studies have shown that when interest rates are pinned to the bottom, countercyclical fiscal policy arising from the automatic stabilizers kicking in and discretionary spending, like infrastructure outlays are highly effective at supporting output.  As a result, one of the things that the Bank wants to explore ahead of the renewal is looking into ex-ante mechanisms to co-ordinate fiscal and monetary policies to deliver better outcomes.  Unlike what we see south of the border, fiscal and monetary policy should be pushing in the same direction.   

With monetary policy potentially less powerful, as a citizen and asset holder, it would be reassuring to know that Parliament Hill and Wellington Street had a framework in place to ensure they would be leaning in the same direction post the next crisis in a timely manner.  Unfortunately, the philosophical and practical hurdles, and their associated risks, attached to some sort of actionable agreement between the Bank and the government are extremely high.

From a historical perspective, if managing inflation is your goal, mixing politics with monetary policy has not worked well.  Canada is a poster child in this area with the resignation of the Governor in 1961 when he set tight monetary policy to counter expansionary fiscal policy.  For a long time, central banks, including the Bank of Canada (after the “Coyne Affair”), worked to get at arm’s length from their political masters to ensure rates were set by economic fundamentals, not set by the electoral calendar.  There would seem to be some risk associated with tampering with this arm’s length arrangement.  

It is probably also fair to ask if the commitment would be binding across governments.  Politicians tend to do what is politically expedient.  The commitment to the inflation target by the current government and the Bank cited in the speech as providing the genesis for an agreement to complementary monetary and fiscal policy in a crisis is only on a piece of paper that could be terminated by the stroke of a pen by the next government (may I introduce Jagmeet when he is confronted by “excessively” high rates that are necessary to quell inflation).  Moreover, this commitment has the Bank accountable to parliament to achieve the inflation target regardless of fiscal policy dictated ultimately by the electorate.  I doubt our elected representatives would want to be seen backing fiscal actions that are contrary to what their voters want; that were triggered by what many constituents view as an arbitrary target.

On the practical side, only in a text book could you come up with ex-ante mechanisms to coordinate policies.  It is difficult enough for unelected officials to enact policy based on their outlook of what will happen.  This is almost impossible for an elected official to risk his career on what may happen.  Political momentum to enact fiscal stimulus beyond the stabilizers almost always happens after the sh** hits the fan (or they feel they are overtaxed, their military is still too small and they don’t have enough debt outstanding).  Even if the triggers (whatever they may be) were correct in anticipating a time when coordinating policies was needed, the political process could easily derail the timing. Fiscal policy, apart from the automatic stabilizers, is not quick and nimble by design.  

Given that monetary policy will not have the same amount of ammo going into the next downturn, it makes sense that the Bank pursues avenues to enhance overall macro policy.  I am just not sure that relying on politicians to act in an appropriately sized and timely manner is the type of assurance the market would want to bet on.  The best bet would be to structure your portfolio knowing the next time things go sour, the safety net below you is now much lower.

The "New" Fed in the "New" Environment

If you own stocks, the last few weeks have been turbulent.  Everyone seems to have a story about why it happened and what it means for the market going forward.  I listen to some of the talking heads and hear how great it is to see volatility back in markets.  The recent dive has acted as a release valve and now we are back to a healthier market.  The captain is about to take the seat belt sign off so the rally can recommence.  The fundamentals, we are told, remain favourable for equities to reach new highs.  Party on, Garth!  

Then there seems to be the deeper thinkers who suggest that there has been a seismic shift under the markets.  Investors had been operating in an environment of slow and steady growth, low interest rates, dormant inflation and accommodative central bank policies which led to a period of extremely low volatility and a relentless bid in all markets, including  equities.  Now, this view has been rattled.  While expectations for economic growth do not seem to have been altered much even with additional US fiscal stimulus, the market seems to have suddenly become aware that we are now in an environment where central banks are reigning in liquidity, yields have jumped higher and there is growing evidence that inflation is not dead.  This “new” environment requires that portfolios need to reposition for higher inflation and need to lower their risk profiles given the expectations of increased volatility.  

Adding to all this is the question as to how the new leadership at the Fed will respond to this “new” environment. The market was well served by Yellen over her term.  Rates were kept low and any increases were well telegraphed and tempered.  Her decision to start unwinding QE was virtually ignored.  Her market-friendly actions and resulting dovish moniker were the result of her setting appropriate policy.  With inflation stubbornly low, she could err on the side of ease.  Now, with Jerome in charge, the market has to consider whether he will be more hawkish than Janet.  For him, his starting point includes firming inflation, with core measures already close to their assumed inflation target.  He also has the economy growing above potential and in an excess demand situation.  Unlike Yellen, who could afford to act slowly, it is doubtful Mr. Powell has the same latitude.  Hence, he will likely be seen as less market-friendly and viewed as more hawkish over his entire term than his predecessor.  

The market already has a number of hikes built in for the next year.  Asset market valuations will depend on whether Fed actions match this profile.  To answer whether they do or not, we are right back to our “old” environment conundrum.  You know the one where inflation remains surprisingly suppressed relative to a given output gap by technology, globalization and other factors.  Unless there is more proof that inflation is really gaining traction and accelerating, I doubt we will see a huge personality change towards more aggressive behaviour coming out of the Fed.  It may take some time before we see the “hawk” in Mr. Powell.   Party on, Wayne!