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Wednesday, January 21, 2015

Bank Of Canada - Policy Error

The Bank of Canada surprised markets (and me) and cut the overnight rate to 0.75% from 1% today. Even though I have been saying that the Canadian economy is doomed for a long time, I think this was a policy error. Interest rates 25 basis points lower will have no measurable effect upon the economy, but it will most likely be interpreted as the beginning of a (very short) rate cut cycle. Since rate cut cycles are almost invariably associated with recessions, the correct question to ask: what does the Bank know? The biggest risk facing the economy is a loss of confidence in the ability of Canadian households to service their debts; increasing uncertainty is the last thing Canada needs. The weaker Canadian dollar will take quarters or even years to help growth (as a result of the J-curve), but confidence within the housing market could be lost within weeks.

5 comments:

  1. I agree with your analysis. The coming recession will likely be a "transition recession". Ultimately, U.S. growth and a weak dollar will lead us to a recovery, but it will take time as you said. Inflation aside, it reminds me of the early 1990s, in a sense it is "déjà vu all over again"!

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    1. It's slightly hard for me to compare; I was an engineering student in England at the time of the transition in the 1990s. There were structural changes in the economy then that I can see in the data, but I have less of a handle what drove them. Monetarists will argue it was inflation targeting, my hunch is that fiscal policy was tightened as well.

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  2. when I talk similarities with the 1990s, it is more about how Canada will recover than the recession itself. Canada's recovery from the early 1990s recession was fuelled by a weak dollar and a booming U.S. economy. It is likely to be the same thing this time around. That said, similarities stop there since the 1990s recovery in Canada was also fuelled by surging private debt, this factor will be missing in action this time around.

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  3. Wasup Joseph! Good point about the rise in private debt in both the US and Canada. Lumber being trucked down to the nascent US housing boom starting in late '95 gave a huge boost to the economy. That situation, I'm afraid, won't repeat itself any time soon.

    Brian: I tend to think in terms of a monetary-fiscal mix. Yeah, I know, that's no so popular anymore. But, it makes sense to think that way. Fiscal in the early 90s in Canada was anything but tight. Monetary policy, however, was extremely tight. On balance, the mix was tight.

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    1. Whoops - I was thinking about the period after the introduction of the inflation target. I do not have the chart handy (need to get the weekly data with a longer run), but yes, I believe that they crushed the condo bubble with higher rates (which was earlier).

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