Central banks face tricky policy test as economy brightens

2014-04-29 15:04:54

U.S. Federal Reserve chief Janet Yellen and Bank of Canada Governor Stephen Poloz share a predicament.

U.S. Federal Reserve chief Janet Yellen and Bank of Canada Governor Stephen Poloz share a predicament.

Key economic signs are starting to improve. In both countries, inflation is perking up, the job market is on the mend and factories are busier.

Yet despite the obviously improving economy, neither central banker is anxious to commit to precisely when they'll start ratcheting up rock-bottom interest rates. Nor are they particularly eager to see higher borrowing costs in the short term for fear of stalling the fragile recovery.

The Fed's interest rate-setting open market committee wraps up a two-day meeting in Washington on Wednesday. The post-meeting statement is widely expected to confirm another step in the Fed's gradual unwinding of so-called quantitative easing, with a reduction in its monthly bond-buying to $45-billion (U.S.) from $55-billion. This would mark the fourth consecutive meeting that the Fed has cut $10-billion from the program, maintaining a course to end QE entirely by the end of the year.

But Ms. Yellen, presiding over her second meeting as Fed chair, is unlikely to change her cautious tone on the pace of the recovery. Nor is she expected to hint at a change in the bank's federal funds rate, set between zero and 0.25 per cent since late 2008.

In March, the Fed announced it was backing off earlier specific milestones for hiking rates to give the bank more flexibility. Analysts don't expect any major changes to that guidance on Wednesday.

Like Mr. Poloz in Canada, Ms. Yellen has stressed the uncertainties buffeting to the U.S. economy in recent remarks, while also casting doubt on the accuracy of some of its forecasting models.

The recovery has been "disappointingly slow," Ms. Yellen lamented earlier this month. "Our consistent expectations for a pickup in growth have been dashed over a number of years," she said.

"And the labour market is behaving in some perplexing ways and showing patterns that are novel."

Mr. Yellen bluntly acknowledged that monetary policy is grappling with "significant unexpected twists and turns."

The economic ground has fundamentally shifted since the financial crisis, making forecasting tricky, according to economist David Rosenberg of Gluskin Sheff and Associates Inc.

"The economic models ... are now fraught with huge error terms," he wrote in a recent commentary.

"For five decades, the economy was pumped by ever-expanding credit creation. Recessions were merely short setbacks and expansions were long and strong. But we are in an entirely new era, globally, after hitting the debt wall six years ago."

In Canada, Mr. Poloz has expressed similar frustration that the bank's models, particularly when it comes to forecasting an elusive pickup in exports. After a speech in Saskatoon last week, he lamented that "our models have not done a good job of explaining exports over the past two years."

And because the economy depends on an export recovery to return to health, Mr. Poloz isn't yet prepared to say if the bank's next rate move will be a rate cut or a rate hike.

There is simply "too much uncertainty to say one way or the other," the central bank Governor told reporters.

If exports are Mr. Poloz's puzzle, Ms. Yellen's problems centre on inflation and the job market.

Prices in the United States, for example, have consistently been tamer than the Fed has expected in recent years.

But inflation is starting to pick up.

The U.S. consumer price index rose at an annual rate of 1.5 per cent in March, up from 1.1 per cent in February.

Core inflation, which excludes volatile food and energy costs, reached 1.7 per cent, up from 1.6 per cent in February.