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Thursday, October 28, 2021

Bank of Canada Comments

The Bank of Canada released its October 2021 Monetary Policy Report, and I just want to make some brief comments.

I would summarise the report as follows: the Bank of Canada has ended its balance sheet expansion (“Quantitative Easing/QE”) in order to have the capacity to raise rates if needed in 2022. Although the bond perma-bears that dominate “serious” economic discussion will welcome this, this can also be seen as a statement of the obvious. Inflation has been running above target for some time, and that is not immediately expected to turn around. If inflation is not back closer to target by the end of next year, it would be very hard for the BoC to claim that it is an inflation-targeter. However, for the bond bears to have anything other than short-term vindication, inflation indeed has to not settle down in 2022.

Central Bank Watching the Easy Way

I will start with two disclaimers. The first to note is that when I was in finance, I always was in firms with senior employees who were previously at the Bank of Canada. The best career strategy in such a situation is to keep your head down when BoC watching comes up. The second point is to remind readers that I am not a forecaster, and thus do not do the work to stay continuously up with the news flow.

That said, I can relay my trick to central bank watching: read their reports, and take most of the contents as being representative of the internal consensus of the bank. This would be viewed as amateurish by professional central bank watchers. Instead, they want to dissect every word, and try to work out the hidden details.

Historically, such an in-depth approach made sense. Central banks used to be opaque, and back in the money supply targeting days (when many of the senior economists started their careers), it was almost impossible to tell what the current policy stance was, never mind what the central bankers were thinking.

The “expectations management” fad among New Keynesians ended that; nowadays, you cannot get central bankers to shut up.

This explains why taking the reports at face value works as a analysis strategy: if there is hidden information, it might only matter for a few months horizon. Near the start or end of a hiking cycle that matters, but not so much when policy direction changes are a year away. It does not matter what the central bankers think will happen next year if the data evolves differently than they expected — they will have to react to realised data, not what they thought would happen. If you want to do macro trading, you just need to see where forecast errors might occur.

In the current situation, what probably matters is whether inflation settles down by the end of 2022. What the central bankers think inflation will do in October 2021 will not matter in June 2022.

Goodbye QE, We Hardly Knew Ye

I was surprised by the adoption of QE by the BoC, such a move did not make sense in the context of the institutional framework in Canada. (The fact that it moves Canada away from the simplified system described in Understanding Government Finance added to my annoyance.) The stopping of the growth of the balance sheet ices the policy off; the balance sheet could run down on its own due to maturing bonds.

I view QE as having very little effect on much of anything, a view that attracts rebuttals from all corners. Since the debate about QE bores me, I will largely leave it at that.

However, based on comments floating around on Twitter, Canadian fiscal conservatives (who dominate the Establishment) are treating this as a signal that the BoC is throwing fiscal policy under the bus. Although I think this is silly, the Canadian Establishment is very happy repeating the same myths to itself, and so this interpretation will end up as the received wisdom.

In addition to probably not helping Canadian policymakers, this myth-making underlines the flimsiness of the neoliberal policy consensus. Fiscal policy makers are supposed to somehow make decisions which can then be vetoed by the Bank of Canada because the Bank suddenly decides that they pose inflation risks. Why not talk to each other? That said, that neoliberal consensus about the structure of policy options appears to be shifting, so perhaps this is no longer a concern.

Elephants in Rooms, and Housing

I am in the camp that small changes in interest rates have ambiguous effects on the economy. However, the housing market is a market that is interest rate sensitive. My views on the Canadian housing market might be affected by living amidst a construction boom around a new commuter rail station, but it seems to me that construction is extremely perky. Construction is also one of the sectors hit by supply chain disruptions.

Cooling the housing market would probably help relieve some of the bottlenecks in the economy. The concern is that housing is a market dominated by leveraged investors, and so “soft landings” may be wishful thinking. This concern, coupled with the possibility of the CAD/USD exchange rate taking off would probably keep the pace of hypothetical rate hikes tepid.

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(c) Brian Romanchuk 2021

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