On Canada's exit strategy

In my previous post, I noted that the Canadian economy was moving towards the end of the recovery phase of the recent recession. But what exactly does that mean in terms of a shift in the government's policy stance? And just when should that shift take place?

Probably the best place to start is the Bank of Canada's estimates for the output gap: the deviation from its estimate for potential and actual GDP. According the the framework in which the Bank works, when a positive output gap means that GDP is above potential and that there are upward pressures on inflation. When the output gap is negative, there are disinflationary pressures.

Here is a graph comparing potential and actual GDP for the period in which the Bank has made its estimates available:

There are a couple of points that I'd like to make here:

• Let's all keep the most recent recession in perspective. At its worst, the output gap hit -3.7%, and it was below -3% for only two quarters. In the recession of the early 90's, the trough was -3.8%, and it was below -3% for 10 quarters. In the recession of the 1980's, the trough was -5.9% (!), and it was below -3% for 5 quarters.
• Let's all bow our heads and give thanks that we're not re-living the early 1990's. Not only were we significantly below potential for more than two years, the growth rate of potential output slowed as well. Ouch.

Let's now zoom in on the most recent part of that graph:

The dotted line for potential is a simple extrapolation of the growth rate over this period (1.7%), and the dotted line for actual GDP is my back-of-the-envelope backcast (2.7%).

Fiscal policy first. As long as monetary policy is effective, the case for an activist fiscal policy - that is, beyond the automatic stabilisers associated with Employment Insurance and the tax system - is generally pretty weak. Fiscal policy is slow, clumsy and easily appropriated by well-connected rent-seekers. But back in the first quarter of 2009, the Bank of Canada was running out of ammunition (that is, its target for the overnight rate was about to hit its lower bound), so it made sense to set aside those misgivings and embark on a policy of fiscal stimulus.

As it turns out, we never really hit the Zero Interest Rate Bound (ZIRB) - although we probably grazed it - so the actual effectiveness of that stimulus package will be a subject of lively debate for a few years. My own view is that it turned out to be ineffective ex post, but that it was a still a good decision ex ante. Buying fire insurance can still make sense even if your house doesn't burn down.

The federal stimulus policy is set to end in 2011Q1. If quarterly GDP growth averages 3.9% between 2010Q2 and 2011Q1 - which would be quite a lot more than the Bank of Canada is projecting - then the output gap will have closed by then.

If we were still stuck at the ZIRB, then this would be a case for extending the stimulus package. But we're not. The output gap has already been reduced by half, and the Bank has already seen fit to increase the overnight target rate by 50 basis points. Moreover, the outlook is for continued increases over the next few months. If a more expansionary policy is still called for in March 2011, the Bank of Canada should be in a position to lower interest rates.

Our exit strategy appears to be to let the fiscal stimulus package expire in 2011Q1 as planned, and to let monetary policy take up the responsibility of providing whatever remains in the way of counter-cyclical policy. From where I sit, that looks to be the sensible path.

Comments

[Rick]

Really though, who cares what the exit strategy is. The real issue is that the problems the Canadian Economy faces aren't on the balance sheet they are in policy. The conservatives are going to hijack the discussion, with the aid of the ineptness of the Liberals and NDP on economic matters, and turn it into whether the stimulus was effective or not (actually more likely conservatives will concede its ineffectiveness in favour of the "we care" prudent argument and go on to cut social programs to pay for it in order to "compromise" on budget issues and "atone" for their compassionate mistake)

We are too advanced of an economy to rely so heavily on resources and turn our back on research, development and manufacturing.

[Kosta]

Hi Stephen,

Nice summary and I especially appreciate the chart comparing actual and potential GDP (1983-2010). I have a technical question regarding the potential GDP and how it's calculated. Over the 2005-2008 period, the actual GDP was above the potential GDP. From what I understand of the actual vs. potential GDP comparison, when the economy is running above its potential, inflation usually ensues. Yet over the 2005-2008 period, Canada did not see inflation. Currency appreciation, but not inflation. So I wonder, how is the potential GDP, as it appears in the figures, calculated. Could the estimate be too low over the 2005-2008 period?

Thanks

[Stephen Gordon]

I suspect the Bank's answer to that question would be that they conducted monetary policy in a manner consistent with its inflation target: inflationary output gaps were countered with a contractionary monetary policy, and disinflationary output gaps were countered with expansionary policy.

And given the available information, it would be hard to contest that response.

[Mark]

Kosta, the Bank's estimate of potential output is lower than other modellers between 2004-2008. The PBO has a nice comparison: www2.parl.gc.ca/sites/pbo-dpb/documents/Potential_GDP.pdf

Potential output growth = productivity growth + labour force growth. I believe in 2009 the Bank revised down their assumptions for productivity over this time period. My 2 cents, this would assume that the Bank's interest rates were much more higher than the equilibrium rate during this period.

[20th century workforce]

I apologize for all my previous criticism, stimulus and otherwise, that I've directed to our leader, the greatest PM ever. CPC never fought the stimulus, never made it the least green stimulus in the world, never put a deadline on necessarily long large projects, and never it directed towards CPC ridings:
http://www.winnipegfreepress.com/canada/breakingnews/retiring-bc-mp-jim-abbott-falls-ill-during-flight-with-stephen-harper-100384924.html

[Angelo Melino]

Stephen, I don't know why you think that we never really hit the Zero Lower Bound. The Bank determined that 0.25 was the Effective Lower Bound (going any lower would have caused enough damage to the overnight market and the money markets that it was deemed not worth it). But it needed to do more. It gave a list of 3 options that it would pursue once it hit the ELB and enacted one: The conditional commitment to keep the overnight rate at 0.25 until the end of 2010Q2.

We may not have crashed into the Zero Lower Bound with the intensity of the US, but we certainly hit it.

[Stephen Gordon]

Yeah, that's sort of what I wanted to convey by 'grazed'. Must come up with a better verb.

[Kosta]

Stephen, thanks for the explanation and the link. You are probably right when you suggest that the Bank's interest rates were likely above the equilibrium rate for the period. But the exchange rate also increased, which undoubtedly helped curve inflationary pressures and probably allowed the BoC to hold rates lower.

Going forward from today, the exchange rate may play a similar role towards monetary policy. If CAD/USD breaks above $1, it could allow the BoC to leave its rates lower.

[Determinant]

Not just the exchange rate, the decreased demand from the United States will significantly impact manufacturing and service demand and related wage growth.

When I say service, I mean things like call centres, most of which in this country service American calls. I used to work in just such a centre.

[Simon van Norden]

Stephen: You're a statistician for God's sake! And here you are drawing graphs of estimates without providing any idea of their confidence intervals.

Did you want to add anything about the reliability (or lack therefore) of recent output gap estimates? Did you want to say anything about the degree to which they tend to be revised ex post? And the resulting implications for policy?

[Stephen Gordon]

Dang. I was hoping that would go under your radar.

Everyone should know that the internet isn't big enough to contain the error bands for estimates of output gaps. And that it matters.

[Declan]

"Fiscal policy is slow, clumsy and easily appropriated by well-connected rent-seekers."

Any evidence for this, or is it just right-wing noise machine background music?

"My own view is that it turned out to be ineffective ex post"

How can you tell? Just a hunch? Seems like the economy turned upwards relatively in sync with the stimulus. Obviously that doesn't prove causation, but it would seem to make it hard to conclude lack of causation.

Personally, I think we need an exit strategy from our high debt levels (household debt in particular), but then you already knew that...

Kosta - I think the potential GDP is calculated by fitting a curve through the actual GDP data :)

[20th century workforce]

I wonder if it wouldn't be too much trouble for the Senate committees or someone to always have some shadow stimulii set up for any given time. It is quick enough to lower bank rates or interest rates. But lots of inefficientcies emerge because the thing is necessarily rushed (unemployed workers with a paycheck to paycheck workforce is no good). It has the deleterious effect of being like those USA add-ons to budgets, I forget the term. But planned ahead would receive scrutiny from media or opposition committees, assuming not shredded documents. There are preferred budget items not normally efficient or gaining political brownie pts, that might be on the table if employment or debt/deficit lower (using servants to supplement Cabinet/PM).

But what I really wanted to mention was I had a friend who claimed another wouldn't give him a glass of water during after school videogames. I thought to myself at the time, "No one could be that mean."

[20th century workforce]

...or stag/deflation, in the context of this thread. Look how hurried Japan's attempts were to spend. Or you could run it in reverse and kill some government fat (reraise GST, kill jets and non-violent prison population increases) to lower BofC rate. Whatever you call a longer term health stimulus, its got to be done and probably can be afforded by undoing everything Flaherty did for banks and tar sands (if you find a health cost saving or value-added programme, make it optional by province). Good trade says this GM.

Now I know. My friend was really denied a glass of water.

[Kevin Milligan]

>>"Fiscal policy is slow, clumsy and easily appropriated by well-connected rent-seekers."

>>Any evidence for this, or is it just right-wing noise machine background music?

How about Canada, 2009-10? That pretty much hits the mark on all three of Stephen's point.

[Simon van Norden]

Stephen:
"Not only were we significantly below potential for more than two years, the growth rate of potential output slowed as well. Ouch."
Are you measuring potential output by filtering actual output? In which case two years of output below potential will necessarily reduce the estimated growth rate of potential?

[Stephen Gordon]

Oh, these are all the Bank's numbers.

But the slowdown in potential is plausible: it was the period of NAFTA-induced structural adjustment.

[Simon van Norden]

Sorry, I don't know how the Bank puts the numbers together these days. If you don't either, you might want to check out whether recessions automatically generate a slowdown in the growth of their estimates of potential.

To put it another way, you might want to ask yourself whether this estimated slowdown seems large relative to the estimation error in the growth rate of potential. (For example, wouldn't it also be plausible for NAFTA to induce a upwards jump in potential due to gains from specialization and economies of scale?)

[Determinant]

That did happen, I worked at jobs that NAFTA made possible, but it took time. NAFTA first killed the protection-dependent industries, especially marginally profitable ones prone to relocate; the upside took time to materialize.

It's much slower to grow a company and add to its potential. It's far easier and quicker to kill a weak company.