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Thursday, April 24, 2014

Reality Sinking In At The Bank Of Canada

Bank of Canada Governor Stephen S. Poloz gave a speech today, which mainly revolved around the mainly impact of high energy prices on the Canadian economy. However, he argued that rates will probably be structurally lower.

The section of the speech on Monetary Policy:
How does monetary policy fit into this? In effect, we make sure the big picture is balanced and we let these forces work themselves out beneath the surface. Our contribution is to keep inflation on track. However, even though monetary policy does not address sectoral or regional issues and, instead, is designed for the economy as a whole, the analysis I’ve described here feeds critically into our policy decision making. 
Our forecast is that, as a result of higher consumer energy prices, total inflation will rise in the next few quarters. These increases will have, by definition, transitory effects on trend inflation and in a year from now, they will come out of the numbers. In the meantime, what is crucial to the underlying inflation story is that we start from a low inflation rate.  And that’s why we say that the downside risks to inflation remain important - because they would have the potential to push inflation significantly further away from our 2 per cent target. If we ask ourselves where those risks might come from, obviously, our story hinges critically on the outlook for our exports. 
We already have what looks like a soft landing emerging in housing, so it is crucial that at the same time there is a pickup of momentum in our exports [emphasis added - BR], which we believe will then be followed by a pickup in business investment.  Those two shifts will put our economy on a sustainable growth track. 
However, if, for some reason, the export recovery were less than we're predicting, then total inflation, having gone up to target, will simply drift back down to converge with core inflation at perhaps around 1 per cent, because the output gap will be just as big as before. 
Either way, it should be clear that we are still a long way from home, as it will take until early 2016 to get underlying inflation back up to 2 per cent. Our economy has room to grow. And, when we do get home, there is a growing consensus that interest rates will still be lower than we were accustomed to in the past - both because of our shifting demographics and because, after such a long period at such unusually low levels, interest rates won't need to move as much to have the same impact on the economy. [Emphasis mine - BR]
They are still hoping for exports to bail out the economy, even as housing appears to be losing momentum. I have my doubts that the export sector can generate even a fraction of the jobs that will be lost in construction as the number of units in the pipeline falls. Their view is not a surprise. The Bank has been calling for the business sector to take the growth baton from housing for about four years now.

But it looks to me that they are dropping their estimate of the neutral rate. The fact that the real policy rate has been zero or negative for years without any sign of acceleration in the economy fits very uncomfortably with their models. I guess the forecast misses were so horrible that they have had no choice but to throw in the towel and change their models' "fixed, structural" parameters.

(c) Brian Romanchuk 2014


  1. In the early 2000s, my main grievance against the BoC was that, on average since it adopted a 2% inflation target, inflation was most of the time lower than target. I viewed this as the result of the BoC's anti-inflation bias. The average rose to approx. 2% given the loosening following the mid- to late 2000s.

    Today, I think the BoC is vulnerable to another set of attacks: that it can't create inflation out of thin air!

    Good post.

    1. If a good portion of the fall in inflation was due to tighter fiscal policy that started in the 1990s, the BoC has been taking credit for something that was outside of its control. That makes what is happening now a lot easier to understand.

      However, given the vulnerability of the housing market, it's not safe to say that monetary policy is impotent. It would be possible to do a lot of damage with monetary policy, it's just that it looks like isn't much ability to stimulate the economy at this point.

    2. About the 90s. Don Drummond is on the record as saying that in the early 90s the Dept of Finance and the BoC's models were predicting increasing inflation during the mid- to late-90s. Drummond now admits the models were wrong. So, yes, the combination of fiscal and monetary policy was too tight.

      As for the impotence issue. I generally believe there is asymmetry. I don't buy the view shared by the unlikely pair of MMT and RBC that monetary policy doesn't matter. A much more sensible view is that when the economy is weak as a result of shocks originating outside of policy, monetary policy is generally ineffective (pushing on a string). Similarly, I tend to agree with the view that when the economy roars, standard monetary policy is weak to slowdown the boom (although it can be done by killing the economy along with it, as Volcker showed it can). All that to say that your point is well taken; monetary policy can work and also can do lots of damage. I just wanted to add the part about asymmetry.


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