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Thursday, July 14, 2022

Bank Of Canada Goes Just Plain Nuts

OK, the title might be too dramatic, but the hike of 100 basis points on Wednesday was somewhat out of the ordinary. Since I am not interested in selling any particular forecast, my interest here is the angle: what does this mean? Unfortunately, the answer to that is not entirely clear. The Bank of Canada (BoC) seems to have fallen in with the crowd that argues that rate hikes ought to be done in one massive hit, and then we wait to see what happens.

The problem with the “let’s rip the band-aid off in one go” strategy is that it implicitly has the assumption that we know exactly what the effects of X basis points of rate hikes are. Sure, the BoC got the policy rate to 2.5% on July 12 — arguably a more sensible-sounding interest rate than 1.5% at current inflation levels — but what do they do on September 7? Do we really believe that the observed inflation readings are going to measurably change by then (beyond the small retracement in gasoline prices that has happened)? If inflation does not turn around, what exactly do they do? Hike by another 100 basis points?

Sometimes, you can have very rapid shocks to the economy, such as the immediate freezing of wholesale financing after the Lehman weekend. However, processes are normally slow — credit markets had been slowly unravelling for an extended period before Lehman. Mainstream economists used to say that “monetary policy has long and variable lags.” Hiking at 50 basis points a meeting would take the policy rate from 1.5% to 3.5% in four meetings, which is the same pace as hiking by 100 basis points twice, then pausing.

Economic Effects?

In any event, I am in the camp that this hike will have that much of an effect on its own. If the Canadian economy enters into a tailspin in the near run, the culprit is going to be developments overseas. The housing market is going to cool, but that will take time. The middle of the Canadian summer is not the optimal time to sell a house, and things like construction and renovations have long lead times.

One common response I have seen is that house prices will fall. The problem with that is that Canadian house prices are hardly measured accurately, and other than the handful of people with active listings, it is hard to know what your house is allegedly worth.

Another standard worry is household balance sheets — will households be able to survive the rise in mortgage payments? The standard financing structure is a 5-year fixed mortgage that is renegotiated at the end of the fixed term, and so a spasm in short rates take awhile to filter into household finances. New mortgages are supposed to have an interest rate cushion in the payments (assuming that underwriting guidelines are not being bent). Meanwhile a 2.5% short rate is still too low to matter. My gut feeling is that you need a policy rate of 4.5% (or a lot more pain at the 5-year point) to really bite into the animal spirits of the housing market — conditional on the assumption that nothing else derails the economy.

Nevertheless, my guess about the sensitivity of the housing market to the policy rate is exactly that. Even though I could spend more time refining that guess, I doubt that the extra effort is going to improve the quality of the guess. The housing market is a market, and market participants act loopy, making the market trajectory hard to predict. If the BoC hikes extremely rapidly until they finally see firm evidence of slowing, the most likely outcome is that the slowing indicates that something has already gone horribly wrong in the innards of the market, and a crash would be guaranteed. Although predicting exactly that is fashionable, the BoC is aware of the concept of household balance sheet fragility, and so some sort of pause is likely.

From a bond valuation perspective, fair value is still almost entirely determined by the terminal rate. The erratic behaviour of the central bank raises the odds of an overshoot, but that is balanced by the possibility that the erratic behaviour causes a panic that snuffs out animal spirits. Since the bank has decided to telescope the hiking into a short interval, one no longer has the luxury of using economic data to gauge where the peak rate will be.


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(c) Brian Romanchuk 2022

2 comments:

  1. Is it possible that the action (the 100 basis points all at one go) is as much undertaken for its "signaling" value as any realistic assessment of its actual impact? After all I hear a lot of chatter about "expectations" and "credibility" when these rates are discussed in the business press and the media more generally.

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    Replies
    1. I had a comment along those lines, but I think I deleted it. Yes, the idea is to attract attention. The problem is: what happens in the next meeting, or the one after that? (Although I don’t see issues with more rapid hikes to get the policy rate to 3,5%, they will need to get cautious at that point.) A relentless 50 bps/meeting without pauses might keep more pressure on overly exuberant people.

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