Worthwhile Canadian Initiative

Why did the Bank of Canada stop cutting interest rates?

Here's why:

As I noted several weeks ago, the low y/y inflation rates we're seeing now are due to a one-off fall in prices that occurred when the CAD hit parity with the USD. Since then, core CPI has been growing faster than the Bank's 2% target. And this trend was clear even before yesterday's May CPI release.

So the surprise isn't that the Bank didn't cut interest rates. The surprise is that the private sector was convinced that it would. From two recent stories in the Globe and Mail:

Why Mark Carney's honeymoon is over: “Our view is that core inflation is a dead issue in Canada and will remain that way for a long time yet,” said Derek Holt, vice-president of economics at Scotia Capital.

Mr Holt was not alone:

How Bay Street got it wrong on inflation: "Twelve out of 12," says Don Drummond, chief economist of the Toronto-Dominion Bank. No, he's not rating the new Sex and the City movie on some bizarre point scale. He's referring to the number of economists at a dozen Bay Street investment dealers who believed the central bank would cut its overnight lending rate again, to below 3 per cent.

I really don't understand how they could have all missed the surge in inflation and/or have convinced themselves that the Bank of Canada wouldn't have noticed it. It's true that no-one at the Bank telegraphed the move. But it's not clear why a central bank with an explicit inflation target would have had to telegraph such a decision; it's something that they should have been able to figure out for themselves.

The Bank of Canada stops and startles

The Bank of Canada held interest rates steady today. Going into the April 22 decision, I thought it was about time to stop the round of interest rates cuts, so I certainly agree with the decision.

But I was a bit surprised at the move. Since his arrival at the Bank in February, Mark Carney has cut rates more and faster than I would have thought prudent, and I hadn't yet seen any sign that he was going to stop. Before the announcement this morning, I was marshaling my arguments for a hissy fit on how the Bank of Canada's anti-inflation credibility was being shredded by a rookie central banker who didn't realise that his job was to control inflation, not provide cheap credit for Bay Street. I may yet throw that tantrum, but not today.

The move seems to have surprised the market as well:

Bank of Canada startles market with no rate cut:  ... Economists and market players had widely been expecting a small rate cut of a quarter of a percentage point to stimulate the economy as it deals with recessionary conditions in the United States as well as tighter credit conditions.

Economists had also said that the central bank could quite easily justify a more aggressive rate cut to confront a slowdown in Canada, or swing the other way and freeze rates in the face of rising commodity prices. But they hadn't picked up any hints from the bank that anything other than a small rate cut was in store, and they assumed the central bank under Mr. Carney would continue the pattern set by his predecessors of preparing markets for a change in direction.

While it's true that it might have been a good idea to make some sort of signal to the effect that the Bank was not going to lower its overnight target, I have to wonder about the economists who thought that the Bank could "easily justify a more aggressive rate cut". The only economists on the CD Howe Monetary Policy Council who called for a rate cut are employed by banks; of the seven academics on the panel, four called for no change, and the other three called for a rate increase.

Comparing central banks' responses to the credit crunch

Here's an interesting graph from the Bank of Canada's Monetary Policy Report:

Yes, yes, I know; it's almost impossible to tell the difference between the UK and Canada in that graph, but if you look at the original document and zoom in to 200% of the original size, you can (just barely) conclude that the UK series is the one that has the second-highest spread as of April 2008. Someone at the graphics department of the BoC deserves a scolding.

Anyway, here is a summary of what the the four central banks in that graph have faced since mid-July, and how they've responded:

• The US: The spread increased by 175-200 bps since July. The Federal funds rate has decreased by 300 bps.
• The euro zone: The spread increased by 125 bps. The ECB hasn't changed its interest rates.
• The UK: The spread increased by 175 bps. The Bank of England reduced interest rates by 75 bps.
• Canada: The spread increased by 125 bps. After increasing its overnight target by 25 bps on July 10, the Bank of Canada has reduced interest rates by 150 bps.

Why the Bank of Canada should stop cutting interest rates

Today's CPI release has generated certain expectations (documented here, here, and I expect in pretty much every story covering the March inflation numbers) that a 50 bps cut in the overnight rate target is in the offing next Tuesday. Those expectations may very well be fulfilled - Mark Carney has been dropping broad hints ever since he announced his presence with authority that more interest rate cuts were on the way. But it's far from clear that another dramatic cut in interest rates could be justified. In fact, there's a much stronger argument for not cutting interest rates at all.

Let's deal with the inflation numbers first. Yes, y/y inflation is - by any measure - below the Bank's target. But this looks very much like a one-off level shift, not a change in the rate of inflation. What appears to have happened is that much of the long-delayed pass-through of the CAD appreciation happened all at once, and the trigger was the realisation that the CAD was trading at par with the USD. Even the most long-suffering, mathematically-challenged Canadian consumer was able to figure out that the price that she was paying was much higher than what her cousins to the south were, and a consumer revolt during the holiday shopping season led to a sudden drop in prices. And a very good thing, too.

But that's not the same thing as a drop in the growth rate of the price level. For the next few months, this one-off fall in prices will continue to show up as a reduction in y/y inflation, but once it's been fully incorporated - sometime towards the end of this year - y/y inflation will jump right back up again.

Now let's consider the effects of lower interest rates on aggregate demand, and in particular, its interest-rate-sensitive components:

• The housing market is doing just fine.
• So is non-residential construction.
• Fixed business investment intentions are looking good.

In the US, there's an awfully good case for trying to pump up the interest-rate-sensitive sectors of the economy. But Canada is not the United States; their problems are not ours, and we shouldn't be conducting monetary policy as if they were. These sectors are at or near capacity; they don't need further stimulus.

Moving on to the credit crunch. This is an exhaustively documented phenomenon in the US, but I'm unaware of a comparably clear-cut case for Canada. The best I've seen is from this speech by Deputy Governor David Longworth a couple of weeks ago, in which he presented this graph:

I'm not at all convinced that the lesson we should draw from this graph is that Canada is facing a credit crunch, and that the remedy is an expansionary monetary policy. These spreads have not shown up in the real economy (mortgage rates are lower than what they were before the subprime crisis hit), so the only thing I see is hard times for those who happen to work in the financial sector and whose livelihoods are directly affected by these spreads. It's probably not a coincidence that in the last two meetings of the CD Howe Monetary Policy Council, the private sector members'  recommendations have been lower that those made  by the academics. Or that bankers are anxious to put forward the notion that a 50 bps cut on Tuesday is somehow a slam-dunk.

I will not be overly distressed by a 25 bps cut. But if the Bank of Canada lowers its target for the overnight rate by 50 bps on Tuesday, it will be time to start talking about a 'Carney put'. And it will also be time for someone to make it clear to the Governor of the Bank of Canada that the instincts learned at an investment bank will not serve him well in his new job.

Mark Carney announces his presence with authority

The Bank of Canada lowered its overnight rate target by 1/2 of a percentage point to 3 1/2 per cent:

[T]here are clear signs that the U.S. economy is likely to experience a deeper and more prolonged slowdown than had been projected in January. This stems from further weakening in the residential housing market, which is adversely affecting other sectors of the U.S. economy and contributing to further tightening in credit conditions. The deterioration in economic and financial conditions in the United States can be expected to have significant spillover effects on the global economy. These developments suggest that important downside risks to Canada's economic outlook that were identified in the MPRU are materializing and, in some respects, intensifying.

The Bank now judges that the balance of risks around its January projection for inflation has clearly shifted to the downside, and, as a result, the Bank is lowering the target for the overnight rate. Further monetary stimulus is likely to be required in the near term to keep aggregate supply and demand in balance and to achieve the 2 per cent inflation target over the medium term.

I was expecting and recommending a cut of 25 bps, but there was a decent case to be made for a reduction of 50 bps. Unfortunately, it was not the case that the Bank made.

The good case would have been based on two arguments:

• Core inflation is still way below its target.
• Credit conditions are tighter than what they were last summer. A 50 bps cut still means that effective borrowing rates are higher than they were when the Bank last had a tightening bias.

The case outlined in the interest rate announcement seems much weaker:

• Now that the current account has gone negative, the CAD is unlikely to appreciate much more in the near term. And if the CAD-USD rate stays stable while oil prices continue to rise, then exports will be somewhat cushioned from the US slowdown.
• Domestic demand has been taking up the slack from weak export growth for the last six years; it's hard to see why we should be panicking about the ability to shift output away from exports at this stage.

So while I'm not overly concerned about the Bank's decision, I am somewhat worried about the reasoning it used to arrive at it. Especially if this reasoning is used to guide future interest rate decisions.

Should we be worrying about a 'Carney put'?

Stackelberg Follower makes a point about the appointment of Mark Carney as Governor of the Bank of Canada that has been studiously avoided by commentators until now:

I remain unconvinced that investment bankers should be running the central bank.

Now, I don't have a pathological hatred that most of them will likely earn more than I ever will if I end up in academia. But I remain unconvinced that anyone who is fundamentally part of the investment community should be running the BoC.

Maybe I should justify this belief? I'll give it a shot. The investment community is a very small part of the real economy. Yes, financial services are the biggest things in the economy, by market-cap, TSX weight, or whatever. And yes, I'm pretty sure a lot of banks add to the bottom line by playing with exotic trading instruments, but their fundemental strength is derived from the average Canadian who is happy with low-cost index funds and fixed income.

It seems that most investment types take this sort of news poorly. I mean, looking at the American whining to rescue equity markets - whining which was indeed sated. Slate has a good article on this: The toddlers who are running the global economy. There is no law that says speculative losses will derail the economy, and I don't think they can, really.

Now, I'm pretty sure even if there come times when Carney caters to the TSX more than I'd personally care for, this doesn't mean the big bad seventies are coming back. By no means. But I'd much prefer someone who can push an agenda I think would be much more profitable in the long run than bailing out Bay Street; things like the stability of the time-path of prices.

This is something worth thinking about. An important part of the Bank of Canada's accumulated stock of inflation-fighting credibility has been based on the flinching certainty that it will not cut interest rates in order to provide a floor for stock prices. When the Bank was being run by career civil servants, this sort of focus was relatively easy to maintain: the decision-makers simply didn't care if they were personally popular on Bay Street. Or anywhere else, for that matter: John Crow is a case in point.

Carney's familiarity with financial markets is his strongest  asset in his new job; the Bank's major challenges over the next few years are likely to involve trying to avoid such things as the subprime meltdown. But he's only 42, and he may be entertaining the possibility of returning to the private sector after his mandate as Governor.

Oh, and the Bank of Canada also cut interest rates

The Bank of Canada lowered its target for the overnight rate by 25 bps, to 4% today. This came as a surprise to pretty much no-one: core inflation is below the 2% target, and everyone can see the signs of a US slowdown. Either of those is a sufficient reason to lower interest rates.

Although the Fed has seen fit to hit the panic button, there's not much reason for the Bank to do so - at least, not yet:

• The Bank still has lots of room for further interest rate cuts, if necessary: the target rate is still two points above inflation. The US federal funds target is now at or below inflation, so real rates there are already pretty low. It's hard to see how the Fed could go any further, especially since US inflation is already starting to drift out of most central bankers' comfort zone.
• The Canadian economy is starting from a much stronger position than is the US economy. While the employment-population ratio in the US is still 2 ppts below its 2001 peak, employment rates in Canada increased by 2 ppts, and have been setting records for the past couple of years.

According to the Bank's statement, "further monetary stimulus is likely to be required in the near term", so we can look forward to another rate cut on March 4. Right now, I'd be looking at another 25 bps, but that opinion is likely to evolve as data come in over the next six weeks.

The CAD appreciation finally passes through to inflation

The long wait for the pass-through appears to be over: according to today's CPI release, core inflation has gone from 2.5% in June down to 1.8% in September. (The headline CPI number was 2.4%).

The only sectors where prices didn't fall were in the areas least affected by the exchange rate: shelter and services. Although it's still unlikely that the Bank will decide to cut interest rates on December 4, we should expect a signal that the Bank is thinking about reducing them on January 22.

Why would the Bank of Canada reduce interest rates on December 4?

The last time the Bank of Canada announced its target for the overnight rate, it decided to keep its previous level of 4.5%, and it said that that it was planning on keeping that rate for at least the next few months. It's been a month since then; is there any reason why the Bank would revisit that policy? Let's look at the relevant facts:

• Inflation is coming down, but perhaps not far enough for the Bank to decide that it's no longer worth worrying about. Core inflation in September was at 2% y/y, but it's been above 2% for a couple of years now.
• Employment growth continues to outstrip that of the working-age population. Employment rates are at an all-time high.
• The Bank's measure of the output gap in 2007Q3 was positive, as it has been for well over a year.
• The exchange rate is pretty much where it was on October 16.

That last point deserves some comment. Here is a graph of the CAD-USD exchange rate since October 16:

The last few weeks has seen any number of panicky demands for an immediate intervention to bring the CAD back down, and not a few people calling for monetary union with the US. But all it really took to bring the CAD back to earth was the release of the September trade balance data.

If the decision were to be made today, I would expect the Bank to keep the target at 4.5%, with perhaps a hint that they would be prepared to cut interest rates in January if inflation continued to drift down, and if inflationary pressures continued to ease. If the October inflation numbers (due to be published Tuesday) or the 2007Q3 GDP numbers show a significant weakening, then the hints of a January rate cut will be more strongly worded.

But the strongest reason why we should not expect a rate cut in December is that the Bank told us not to expect one. And the Bank's announcements of future intentions are a very good predictor of what it actually does.

The Bank of Canada shifts back to neutral

As predicted, the Bank of Canada decided to keep its overnight target at 4.5% on Tuesday. That's twice now that the Bank has put off applying the tightening it started in July, and it looks as though this temporary pause has now been upgraded to a medium-term strategy. The October Monetary Policy Report (32-page pdf) outlines the combination of tighter liquidity in financial markets and the worse-than-previously-expected outlook for the US economy behind the move.

It occurs to me that I've spent a lot of time recently blogging about the Bank of Canada. Now that they've committed themselves to doing not very much for the next few months, I'll try to find other things to write about.