Canadian monetary policy if half the world turns Japanese?

The latest Statistics Canada Labour Force Survey confirms the impression that the Canadian economy is recovering well. Inflation is still a little below the 2% target, but should rise as the recovery continues. The Bank of Canada's overnight rate target is at 0.50%, which is much lower than normal, and is clearly negative in real terms. The Bank is expected to increase to 0.75% on Tuesday, but that would still be much lower than normal, and still negative in real terms. So unless something goes badly wrong, the Bank of Canada should continue to tighten monetary policy over the next year or two.

But what does "tighten monetary policy" mean? Especially in the current context, where things look a lot less rosy in the rest of the world?

Japan turned Japanese in the 1990's. Japan's economy is not small, compared to other countries. But it is small compared to the whole world. Japan's turning Japanese didn't affect the world very much. But if both the US and the Eurozone turned Japanese, that's a big chunk of the world. What would it mean for Canadian monetary policy if Canada recovers fully, but half the world turns Japanese, with very low nominal interest rates and zero inflation, or even deflation?

As I have said many times before, monetary policy is not the same as interest rates. Tight/loose monetary policy is not the same as high/low nominal interest rates. That is true in a closed economy. It is even more true in a small open economy, like Canada's. In an open economy, the exchange rate, though far from perfect, is a better indicator of the stance of monetary policy than the interest rate. For one thing, at least it moves in the same direction to monetary tightening in both the short and the long run.

Just to keep the thought experiment simple, assume that the whole world, except Canada, turns Japanese, with 0% inflation and with central banks setting 0% interest rates on overnight loans. But Canada stays, um, Canadian, with inflation at the 2% target and expected to stay there. What would the Bank of Canada need to do to keep Canadian inflation at the 2% target?

Under perfect capital mobility, the real rate of interest is set in world financial markets. And with 0% nominal, and 0% actual and expected inflation, the world real interest rate is also 0%, by assumption. With perfect capital mobility, and if we supposed that the real exchange rate was not expected to change, that means Canada would have to have 0% real interest rates too.

So here's the scenario: The Bank of Canada sets the overnight rate target at 2%, the actual and expected inflation in Canada is 2%, so the real interest rate in Canada is 0%, the real exchange rate is constant, and expected to stay constant. But the nominal exchange rate of the Loonie is depreciating, and expected to continue depreciating, at 2%, so lending in Canadian dollars at 2% nominal gives the same rate of return as lending in US dollars or Euros at 0%.

Could that scenario be an equilibrium? Yes, but with one caveat. If the demand for Canadian-produced goods was stronger than demand for Rest Of the World-produced goods, relative to what it was in the past, then the real exchange rate for the Loonie would have to be at a higher level than it was in the past. Otherwise, 0% real interest rates in Canada would be too low to prevent excess demand and inflation rising above the 2% target. The real exchange rate has to be at a high level to compensate for the low level of the real interest rate.

In a small open inflation targeting economy, the level of the exchange rate adjusts to handle permanent shocks to Canadian demand relative to ROW demand. The interest rate differential adjusts to handle purely transitory shocks to Canadian demand relative to ROW demand. And for temporary shocks, which are partly transitory and partly permanent, both the exchange rate and the interest rate differential adjust.

So the scenario I have just described makes sense if it is a permanent scenario, or is expected to be. If it's temporary, so that people expect the ROW to recover soon, then the real interest rate in Canada would have to be above 0%, since people would expect the real exchange rate to depreciate as the ROW recovers, so Canada would need to have its real interest rate above the real interest rate in the ROW, to compensate for the expected exchange rate depreciation and maintain equilibrium between lending in Loonies and lending in US dollars and Euros.

Bottom line: if half the world turns Japanese, but Canada doesn't, look for Canadian nominal interest rates to rise, but stay below levels that were considered normal in the past. Real interest rates in Canada will be lower than normal. And look for the real exchange rate to be higher than levels that were considered normal in the past.

Two final twists to my story:

1. The US dollar is the world's reserve currency. It is the most liquid of all assets. When a financial crisis causes (is caused by?) a rush for liquidity, there's a rush into the US dollar, and its exchange rate appreciates. This complicates the story for the Loonie's exchange rate, since we commonly measure it against the US dollar (as we should, by and large, since the US is our biggest trading partner, and there's probably a high cross-elasticity between US- and Canadian-produced goods). That complicates my story. It means a lower Canadian exchange rate, and higher interest rate, than in my story.

2. What if Canada turns, not Japanese, but Swiss? What if we become an international safe haven, with low debt and deficits? That complicates my story too. It means a lower Canadian interest rate, and higher exchange rate, than in my story.

Comments

[Stephen Gordon]

I think that first final twist (when did we start talking about diving?) would be a transitory thing; once it was dealt with, we'd go back to your baseline scenario.

[Kosta]

Thanks for the post Nick. This is a question that I have also been thinking about, although not as clearly as you. But I've been taking a slightly different perspective to the question of what happens if Canada recovers but the rest of the world turns Japanese. What I've been considering is what happens if Canada's real growth rate returns to "normal", say 3%, while the ROW remains subdued, say 1%, I believe this would be consistent with Canada's inflation rate normalizihg at 2%, while the ROW normalizing at 0%, although I could be wrong about my base scenario.

Given your above analysis, does a higher expected real growth rate for Canada compared to he ROW change anything? Would not a higher expected real growth rate attract capital from abraod (particularly the U.S.), which in turn would drive up the exchange rate and lower interest rates? This is the effect that you already predict, but wouldn't a differential in growth rates magnify this effect?

I'm particulary worried about the possibility of hot money chasing higher yields in Canada leading to distortions and potential bubbles.

If such inflows became large enough, would not the BoC start to lose control over the speed of the economy? Well, it will never lose control over short-term rates, but couldn't the inflow the capital overheat the economy while pushing down long-term rates and pushing up the exchange rate forcing the BoC to make ineffective policy moves?

I believe there is a "hot money inflow" potential in Canada's future, if the rest of the world turns Japanese.

[Simon van Norden]

"In an open economy, the exchange rate, though far from perfect, is a better indicator of the stance of monetary policy than the interest rate."

Once you agree on a model, it may be a better indictor.

However, disagreement over the determinants of exchange rates is legendary. Some think that real shocks (and expectations of future real shocks) have or should have exchange rate effects. As a result, economists are unable to agree on exchange-rate based indicators of monetary policy.

Don't go there, Nick. It is a bad place.

[Simon van Norden]

Two other twists that you may want to worry about:

1) What if people think that the financial crisis and its afterlife has change the trend rate of productivity growth in the US relative to that of Canada? (And I've seen people argue that this trend break could go either way....)

2) What if people think that the "Japaneseification" of a larger chunk of the world has an important and persistent negative effect on the demand for natural resources and their prices. (This would be negative terms of trade shock for Canada relative to US, no?)

[Kosta]

Although a single data point does not a trend make, the month of May was a great example for the potential of "hot money" seeking yield in Canada.

Statistics Canada said the May investment was up from $12.36-billion in April and nearly triple the $8-billion expected by analysts in a Reuters poll. Foreigners pile into Canadian securities (Globe and Mail, July 19, 2010)