Testing the Bank of Canada's neutral stand

Posted on 07-23-2014 08:07
Summary: WASHINGTON -- The Bank of Canada says it's just going with the flow: If economic data in the months ahead get stronger than currently expected, it will ready for higher interest rates; if economic conditions unexpectedly worsen, the central bank says it is prepared to cut its benchmark interest rate from its already ultra-low setting of 1 per cent.

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WASHINGTON -- The Bank of Canada says it's just going with the flow: If economic data in the months ahead get stronger than currently expected, it will ready for higher interest rates; if economic conditions unexpectedly worsen, the central bank says it is prepared to cut its benchmark interest rate from its already ultra-low setting of 1 per cent. For now, the central bank is totally neutral.

Craig Alexander, chief economist at Toronto-Dominion Bank, doesn't really believe it. His latest commentary is inspired by a question about whether the central bank really could surprise and cut interest rates. Mr. Alexander politely considers the question, saying the possibility "is not ridiculous given some of the recent economic developments." Then he goes about demolishing the idea almost entirely.

Bank of Canada Governor Stephen Poloz made a convincing argument last week about why an annual inflation rate of 2.4 per cent is a mirage, and that the more important worry is lessthan-vigorous economic fundamentals such as weak exports and lacklustre business investment. Mr. Poloz also expressed his "serial disappointment" with the economy as the central bank again reduced its forecasts for economic growth.

Disappointment is a condition of the past, not the future. Canada's prospects hinge on exports, which makes the U.S. economy's trajectory the most important leading indicator of Canadian growth. The Bank of Canada last week reduced its outlook for U.S. economic growth this year quite significantly, but that's already history. The central bank's forecasts for economic growth in the United States in 2015 and 2016 were little changed, suggesting there's little need for extra stimulus.

There's also a possibility that the Bank of Canada is too pessimistic about U.S. gross domestic product. The Federal Reserve's policy committee in June predicted GDP will expand between 2.1 per cent and 2.3 per cent this year; the Bank of Canada's new forecast is for U.S. growth of only 1.6 per cent. If the Fed is right, the U.S. demand that the Bank of Canada is waiting for could come back faster than it currently thinks. (The Fed forecast came out before the Commerce Department's final revision of its firstquarter GDP estimate said the economy contracted at an annual rate of 2.9 per cent, which was far bigger than anyone was expecting. Yet, there still is a qualitative difference between the Bank of Canada and the Fed on the strength of the U.S. economy. Fed chair Janet Yellen last week said virtually all the first-quarter decline was the result of the unusually harsh weather, while Mr. Poloz still was suggesting he thinks the U.S. recovery has lost a step.)

Canada's financial authorities have done a good job of curbing a scary escalation in household debt. Credit growth is more in line with wage growth, and builders are putting up houses at a rate that roughly matches increases in the population. But debt is levelling off at an extremely high level, and Canada's housing prices are among the highest in the world when compared to rents and incomes. The Bank of Canada needs to dissuade households from taking on more credit or amplify the threat of a housing bust. The economy would have to reverse course quite dramatically to justify a rate cut under these financial conditions.

Mr. Alexander raises another point: Would lower borrowing costs materially change anything? With the benchmark rate at 1 per cent, money is already very cheap for those who want some. "The only thing a cut in rate would likely really do is lower the value of the Canadian dollar," Mr. Alexander writes.

Ah yes, the dollar. This is where any discussion about the prospects of a rate cut in Canada must lead. Mr. Alexander observes that "monetary policy is not supposed to be targeting the level of the exchange rate." And it doesn't, directly. But given Canada's chronically weak productivity rates, the exchange rate is an outsized factor in the profitability of too many companies. Profitable companies are confident companies, and confident companies invest and take advantage of export opportunities.

The Bank of Canada isn't targeting the exchange rate, but it knows what happens if it gets too strong. That's why the central bank is neutral, even when you'd find no one who would give you even odds that Mr. Poloz's next move will be a cut. By keeping alive the possibility of lower interest rates, the Bank of Canada is actually reinforcing its message that it intends to keep borrowing costs where they are for a considerable amount of time.

Removing that possibility would be akin to lifting the floor for the exchange rate, which would only mess up the fine balance that has taken Mr. Poloz about a year to achieve.

JEFF McINTOSH FOR THE GLOBE AND MAIL

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