Disinflation continues, and the case for intervening in the forex markets gets stronger

The September CPI report was published last Friday, and the disinflationary trend of the last few months hasn't yet stopped:

As I noted at the last interest rate announcement,

1. Up until the crash in commodity prices, Canada ran a current account surplus, so an appreciating currency made sense. But now that we're running a current account deficit, it doesn't.
2. The last time the CAD hit parity with the USD, we saw a sharp drop in consumer prices; even the most arithmetically-challenged Canadian consumers revolted when they could see that they were paying higher prices than were being charged in the US. Consumer prices are already below the path that the Bank would like to see.

If we weren't already at the lower bound, I think that we would have expected the Bank to cut interest rates today. I can think of several reasons why the Bank would want to engineer a temporary depreciation in the CAD, and I can't think of a really good reason why it shouldn't.

Comments

[anon]

Do you think they should buy US dollars (Patty Croft not) and issue bills/bonds, or just leave the money and reserves as is?

[Too Much Fed]

I'll try again.

"If you want to raise price inflation, lower the CAD, and probably raise interest rates, what should be done?"

[Christopher Hylarides]

They should not intervene in the forex market. Period. Every time a country attempts such a move, it invariably bites them back. Whether it's asian countries, Britain, whomever, they always cause an expensive crisis.

Look, if the dollar's rise is due to speculation it will correct itself in short order. If it's due to fundamentals, then we'll have to adjust. We'll have a higher standard of living and we'll have higher productivity. This is something we've been trying to do for years.

Canada running an account deficit doesn't necessarily affect the dollar, so long as somebody is holding those loonies or using them to invest back in Canada. The USA ran a deficit for decades and their dollar maintained a high value compared to most other nations. This is because somebody (mostly China in the past decade) was willing to hold on to those dollars for whatever reason.

[Stephen Gordon]

Since we actually do want the (temporary!) boost in inflation, I don't see much point in trying to sterilise the intervention.

[Erin Weir]

My take on Friday’s CPI numbers was also that they should embolden the Bank of Canada to lower the Canadian dollar.

[Christopher Hylarides]

The only people that want a boost in inflation are people who would like to show our GDP is growing again, but it would be false growth in real terms.

In specific circumstantial theory temporary inflation works, but how often does 'temporary inflation' actually happen? What happens when it's time to scale back in inflationary policies? We get sent back to square one.

If anything a higher Canadian Dollar allows us to actually buy more things from more people, as everything (or at least the vast majority of consumer goods) will be cheaper. If that iPod now costs half as much, I can now also buy something else with that half of the money I saved.

[Patrick]

What good is the cheaper iPod if my export dependent job just disappeared?

[Christopher Hylarides]

It means you'll pick up import dependent jobs. Or resource dependent jobs. Or higher productivity jobs. We'll be putting complex things together instead of just making the simple parts. A higher valued currency didn't destroy the overall economy of Britain, the US, or Germany (which had one of the highest valued currencies in the EU before the Euro). They found more productive places work. Some industries will no longer be competitive (true), but that doesn't mean systematic long term unemployment.

[Patrick]

Well, we may want the economy to evolve in the direction you describe, but we have to deal with the economy we actually have, not the one we wish we had. I doubt that the current Canadian economy can morph into something that looks like the German economy without suffering an extended period of severe unemployment. Put crudely, you ain't gonna change rig pigs into tool and die makers overnight.

[rjs]

if you see a sharp drop in consumer prices, why would consumers revolt?
is that worded wrong?

[Stephen Gordon]

Other way around: the consumer revolt led to a reduction in prices.

[Christopher Hylarides]

Patrick: Yes, of course you will have to go through a period of unemployment, but it doesn't have to be severe if you let it happen without trying to stop it. If government bailouts and subsidies over the years didn't try to maintain in vain Ontario's auto manufacturing industry, it could have died a slower death on it's own instead of the sudden collapses we keep getting when we need either a massive bailout or to let them all die off at once. People could have gradually moved on to other occupations or industries. We could have released those people into building windmills, driving trucks, whatever.

This is part of what the 'natural' rate of unemployment is, and part of why unemployment numbers are misleading to the overall health of the economy. A better measure is how long those people are unemployed for. However, in 'dealing' with the economy we have we tend to actually make things worse. 'Dealing with the economy we have' led us to stagflation. :-/ We're still a long way off, but it's not impossible to end up back there. It will be interesting to see what happens when the stimulus money in Canada is 'used up' and how the economy fares. Spending tons of money all over the place has made the conservative party popular and there'll be pressure to continue it to both 'help' the economy and buy more votes. This is ironic because it's the opposition parties that pushed the conservatives into implementing it.

I disagree with general interference in the economy, but it's always interesting to see how it plays out when people do.

[Patrick]

Christopher: I see nothing noble in accepting high levels of unemployment. We're just (technically) out of a bad recession, and growth has been below potential. I think it makes sense to get levels back to where they ought to be.

The main argument I can think of against devaluing is the 'beggar thy neighbor' problem. I don't imagine that Congress would be thrilled by the BoC intervening to devalue, and they could use it as an excuse to raise trade barriers that would more than offset the benefits of the lower currency.

[Andrew F]

Somewhat off-topic, but something I've been wondering: do changes in relative price levels affect exchange rates?

If the US were seeing 3% long term inflation and Canada saw inflation at 2%, would that tend to cause a ~1% increase in CAD:USD. That makes intuitive sense, but I seldom if ever hear that point made.

[Matthew]

Stephen,

How exactly would the bank intervene in forex markets?

[Andrew F]

It doesn't seem that complicated. Buy US government bonds and sell Canadian dollars. Just like the Chinese...

[Christopher Hylarides]

Patrick: You have to lose your current job (voluntarily or not) before you can have another better one. I'm not saying unemployment is desirable, but it's necessary for the long run health of the economy and everybody. People need to no longer be working in unproductive jobs. Otherwise we'd still have blacksmiths and 80% of Canadians working in agriculture. But over the course of half a century we vastly increased food production with only a fraction of the number of people working in the trade. Those people were freed up to move into other fields. There are programs to soften the blow today(EI, if it was run properly). People move on. If you'd prefer permanent underemployment instead of temporary higher unemployment, then we're going to have to leave it at that and agree to disagree.

Andrew: There are other factors that affect exchange rates, but that basic premise is true. Looking at inflation from a monetary perspective, money is subject to the same supply and demand forces as everything else is. In theory, Canada could completely halt the printing presses or even destroy money today and if say oil prices collapsed (in reality you'd need more than just oil prices), then there'd be less worldwide demand for Canadian money to buy our oil and the value of the dollar would go down, despite the fact there's less Canadian dollars around. Consumer prices are used to measure inflation, and price inflation usually reflects a growth in the money supply after productivity increases is removed.

[Stephen Gordon]

It doesn't seem that complicated. Buy US government bonds and sell Canadian dollars. Just like the Chinese...

Actually, the interesting question is what the Bank does with the USD assets. Use them to pay down foreign debt? What?

[Matthew]

Does the bank need to sell CDN dollars and buy US bonds? Couldn't it just increse the money supply (i.e. print more money)?

[Patrick]

Christopher: What are you on about? I never argued the economy shouldn't evolve. My point remains: growth has been below potential, unemployment is higher than it would be had we grown at potential, and that's a big problem. Devaluing, which boasts NX, is one way to help restore growth to potential.

[www.facebook.com/profile.php?id=611985302]

Unemployed people don't get better jobs. Unemployed people get worse jobs. Employers exploit unemployment to reduce wages and working conditions.

If there are better jobs in a developing economy you don't have to be unemployed to take advantage of them. You get the better job and then you quit the bad one.

[Christopher Hylarides]

Patrick: Devaluing temporarily boosts NX. After things reverberate and rebalance you're left at square one again, but now your businesses will have trouble buying equipment needed to stay competitive. Eventually somebody in a country that didn't purposely devalue their currency will be able to buy more productive equipment that you'll have to compete against and make better, higher quality products.

Want a textbook case? Compare Italy and Germany. The Germans, whom had raging inflation on two separate examples in recent memory (after WW1 and WW2) took an extremely cautious and strictly low inflationary monetary policy after WW2 when they introduced the Deutsche Mark (so much so that it was the world's second largest reserve currency after the US dollar). Italy continuously devalued their Lira post-war; Germany did not. Both have/had largish auto manufacturing sectors. Heck, Italy was ahead of Germany for quite some time as they didn't have the same level of destruction after the war that Germany did. Italy had a lot of temporary export booms when they devalued their currency again and again, but eventually they had trouble competing with superior quality German cars. They were more advanced and a better overall value. The Italians couldn't as easily afford the higher end equipment as the Germans could. Germany became more competitive, despite a higher valued currency. They became more productive. By the time the Euro was introduced the Germans had more, and higher paying, automotive jobs than the Italians did. The proof is in how many Volkswagens and BMWs you see on the road compared to Fiats or any other number of defunct Italian companies. The same is true in many other industries. Germany had to go through some temporary pains to get there. When Italy (or France for that matter) devalued, the Germans had to adapt and that caused some pain. The same is true for other countries.

Look, I'm not cheering on unemployment. What I'm advocating is better jobs. You don't get there by continuously bringing down your standard of living. I'm not saying unemployment itself causes better jobs. Unemployment is a symptom of there having been too many unproductive jobs. Countries that had high inflation for long periods of time had to have brutal recessions so bad jobs could stop and people could move into better ones. It happened in the US and Britain in the early 1980s, Chile in the 1970s, Canada in the early 1990s...Why has productivity lagged in Canada for so many years? It's because we couldn't afford to become more competitive. Similarly, if somebody in quebec makes a better mousetrap than somebody in Ontario should Ontario have it's own currency to devalue and remain competitive?

Jim: If your statement had any validity average salaries would have been on a long term downward trend. Some unemployed have to take worse jobs, yes of course. This is especially true during a recession. Long term working conditions have improved and salaries have gone up in countries that don't try to overly manage their economies. Bad companies have bad levels of turnover and they don't do very well over the long term. Companies don't exploit workers who desperately need a job any more than employees exploit employers in sectors that have severe labour shortages.

[Patrick]

Christopher: again, I have no idea what you're getting excited about. Devaluing to boost NX to help us get back to potential after a severe recession IS a short term policy. I never said that the BoC should turn on the printing press and walk away. And it isn't clear to me that devaluing would preclude restructuring. It's not picking winners like a bailout. For example, would making the lousy GM cars nobody wants 5% or 10% cheaper suddenly make them desirable? Doubt it. But it might give an entrepreneur doing something new a leg-up to get established in international markets and create some new jobs.

I'm not sufficiently familiar with the economic history of Germany or Italy to debate it with you (and I'm skeptical of it's relevance to Canada in 2009), though I suspect productivity and politics have more do with their differences than the relative value of their currencies.

[Andrew F]

Isn't this more about preventing deflation than helping exporters?

[Christopher Hylarides]

Andrew: It will also be harder for those entrepreneurs to go and get new equipment, parts, etc from abroad to get that start. "potential" is a relative term. What is potential? 3%? 2%? What I'm saying is we'll hit that unmeasurable metric with a higher standard of living and better jobs without the devaluation, which will have the effect of increasing prices and hurting savings the most for those on fixed incomes and the poorest of society instead of steadily creating better jobs.

or example, would making the lousy GM cars nobody wants 5% or 10% cheaper suddenly make them desirable? Doubt it.

It could, and it temporarily probably would. However, it would mean that they wouldn't have to improve their cars to compete and it could be more expensive for them now to do that. For some reason people still buy GM cars. If it suddenly got a bit cheaper and you were looking for 'value' it would be more desirable for people who value price.

though I suspect productivity and politics have more do with their differences than the relative value of their currencies.

That's what I'm saying. :-) The Italians were willing to do that because a large enough group of special interests convinced politicians and the public there that it was the right thing to do. I think they're worse off for it.

Andrew: Recently the bank has been murmuring about the dollar hurting the economy and surmising that may intervene, which is going beyond its inflation targeting mandate. That's why this debate 'rages' on. Price deflation in itself isn't necessarily a bad thing unless it's being caused by monetary contraction, otherwise it's just industries being more efficient or getting rid of a glut of inventory (it's most likely the latter in this situation). Computers for example have been in price deflation for decades, yet the tech industry hasn't been worse off because of it.

Personally, I think the story here is a combination of speculation and the devaluing American dollar. If you compare our dollar to the rest of the world, you'll see it's remained relatively stable. If anything we should be pushing to expand our trade relationships beyond the US. Chasing the American dollar on it's way down is not good policy as a devalued American dollar will effect their aggregate demand within the country anyways, and we'll just be poorer with them.

[Darcy]

I tend to lean towards Christopher side of the argument here. It is easy to engage in easing and devalue the currency but the gains are hollow and a band aid cover of inefficient productivity. Long-term there is no free-lunch, we may as well improve and adapt now; we will come out even stronger....

[Stephen Gordon]

True, but I'm talking about an explicitly temporary intervention. Once inflation is back up to the target and/or interest rates move away from the lower bound, then the Bank should stop intervening.

[Andrew F]

And this seems to be a strategy to flatten currency fluctuations. When the currency is worth more (less) than it ought to be, and inflation is low (high), sell CAD (sell foreign reserves). This doesn't try to resist the long run trends, just dampen speculation.

[Patrick]

Christopher - I too was thinking about a short term intervention. I wouldn't normally support forex interventions, but I think the forex market is pretty clearly nuts/wrong/stupid - as Stephen noted in a subsequent posting.