Fed Outlook For 2015

The upcoming year should see some monetary policy drama one way or another. What I see as a base case view - which appears to be a consensus position amongst economists at the time of writing - is that the Federal Reserve ("the Fed") will start to tighten around mid-year. However, the global economy is deteriorating, which poses the risk of derailing the tightening train. Since I do not have enough information to strongly support one outcome over the other, I will just give what I see are the best arguments for hawkish and doveish scenarios.

Fed Outlook: Autopilot Until 2015?

As a short update to my Fed outlook piece, it looks like the base case is that the Fed will continue to taper by $10 billion per meeting. Things only get really interesting at the end of this year, as Fed decisions will become meaningful again in early 2015. In the meantime, the main topic of interest seems to be tail risks, in particular, recession risks.

(NOTE: My 2015 Outlook for the Fed is available; updated in November 2014.)

Taper! Taper! Taper!

Well that was exciting. So far my forecast that this would be viewed as a policy error was wrong, but in my defence, it's too early to say...

Canada Medium-Term Inflation Outlook: 2%

The chart above shows the long run history of the level of Canadian CPI; it has a lot of similarities to what happened in the United States (and similar countries). It is relatively easy to see the change of regime that started sometime in the 1960’s; the move from a relatively stable price level to a steady rise.

The chart below shows the latest regime Canada has entered into since the early 1990’s: a stable rate of inflation around 2% for core inflation (ex- energy and food prices). This period coincides with the Bank of Canada (BoC) have an inflation-targeting mandate, with the target at 2%. The Bank has hit its target throughout the period, for all intents in purposes.

Even if we add in energy and food prices, inflation has been on target over the cycle: the annualised 5-year inflation rate has only varied from 1.2%-2.5% for periods ending from 1995-2013.

This has meant that forecasting medium-term inflation has not been a particularly useful exercise for almost two decades. It was simpler, and probably more accurate, to take the BoC at its word, and plug in 2% as an inflation forecast.

From the point of view of a bond investor, it has only been worthwhile worrying about modeling inflation more accurately if you traded short-term index-linked debt (under 5 year maturity). But in the case of Canada, such short-term instruments do not exist. If you are analysing 30-year Real Return Bonds, you need to forecast breakeven inflation (market expected inflation) for a long expectation horizon. Those expectations are driven by other forces than what will happen to the components of CPI over the next few months.

Although it is clear that inflation forecasting ended up being a waste of time for the past two decades, is that true going forward? If you believe that inflation is essentially 100% under the control of the central bank, you can worry about a change of objective. If you instead think the BoC was lucky and hit its target by accident, you could then worry about whatever special factors held the inflation rate stable could evaporate. And one could easily have made a complacent forecast about inflation in the mid-1960s based on stable realised inflation, with disastrous results.

I do not have a short answer, or even a long answer, to those questions. My instinct is that the low inflation is a structural phenomenon, and so it will not easily evaporate even if the BoC misses a few forecasts. Yes, the BoC inflation target is part of those structural factors, but it is not the only factor. The similarity of inflation outcomes since 1990 for most developed countries indicates that there are some other factors in play, aiding monetary policy.

The real risk appears to be a structural changes to the policy mix: both monetary and fiscal policy. My reading is that there is no constituency for such a change, at present at least. All one can hope to do is monitor developments, and see whether the trends are shifting. And this is not just true for Canada; the same structural inflation stability is seen in the United States, Australia, and the United Kingdom (although the U.K. has had perkier inflation). Japan is a special case of having price level stability.

In Conclusion: medium-term inflation forecasting is not a modeling exercise; instead it is an exercise of imagining what structural changes will allow inflation to take hold, and monitoring whether those developments are occurring. To what it extent it matters, I still would keep a medium-term inflation forecast unchanged at 2%.

(c) Brian Romanchuk 2013

BoC Outlook: Beware The Discontinuity

The Bank of Canada (BoC) is stuck in tough position, and I expect them to keep rates on hold for a considerable time. This is already discounted. However, there are interesting possibilities on a time frame longer than 18 months. A standard mode of thinking is that changes to the policy rate will have only incremental effects on economic growth; however I see that there are risks of a big discontinuity in how the Canadian economy would respond to hypothetical rate hikes.

To start with the easiest part: the Target for the Overnight Rate is 1%, and I do not sees rate cuts on a reasonable forecast horizon. Instead, the only debate is when and by how much the policy rate will be hiked.

My view is conditioned on the Fed outlook; if you think the Fed will hike before 2015, the Bank of Canada will follow suit. This is not just a question of the outlook for the global economy; instead my reading is that the BoC would prefer to hike rates earlier, but they are constrained by the inability to widen the short rate spread of Canada over the U.S.

Using standard “output gap”-based reasoning, the current policy rate makes little sense. The bank expects the economy to close its output gap by mid-2015; hence the policy rate should be “normalised” by about then. Since inflation is forecast to be 2% then, the policy rate should be closer to 4% than 1% by mid-2015. This implies a bias to hike rates, soon. This recent speech by Governor Poloz was a not-very subtle signal of this: I counted 20 uses of variants of the words “natural” and “normal” in the description of the economy.

This style of thinking led to Canada’s tentative hike campaign that started in June 2010, where the policy rate was hiked from 0.25% to eventually 1.0%. Using a single-good economy model, the worst thing that a too-early hike can cause is slightly slower growth, and so inflation will end up slightly below forecast. The reasoning is that the impact of changing policy rates will be a nice, smooth function, and so a small policy error will only have a small impact.

However, I think that there is a significant risk of discontinuous behaviour in the Canadian economy; the problems associated with a multi-good economy are very present. As I discussed previously; Canada is currently in a “good equilibrium”, but it can move abruptly to a “bad equilibrium”.

For simplicity, I will frame my discussion around the evolution of one economic variable: construction employment.

There are three possible evolutions for Construction Employment:

1. Imbalances Increases. Construction (and related) employment remains at "too high" levels, which means that unsold condos will pile up even faster (plus empty shopping centres, etc.). Even if one believes that Canada has not overbuilt housing units yet, it is clear that continuing to build units faster than household formation guarantees a big crash at some point. Canadian policymakers are using “macroprudential policy” (tightening loan rules, etc.) to prevent this outcome.

2. Catastrophe. Employment in Construction falls, and there are no other sectors that replace those jobs. Canada follows the U.S. path of massive job losses, as a downward spiral in demand wipes out the labour-intensive consumer-facing sectors (e.g., Restaurants, Retail, (Household) Finance).

3. Rebalancing. Employment in Construction falls, but other sectors step up to absorb workers. If there is a recession, it is localised and manageable. A bit of Austrian Creative Destruction ensues.

Central bankers are not sensationalist bloggers, and operate under strict rules of behaviour with regard to their discussion of the economy. So it is no surprise that their implicit forecast is the gradual rebalancing scenario. (They do not make public forecasts about employment by sector, but they do discuss the components of GDP, and their central forecast appears to imply my scenario #3.)  And in Governor’s Poloz speech, he argues that there are signs that the rebalancing scenario is the correct one. But a cynic would note: rebalancing has been the Bank’s forecast essentially since the end of the crisis, but since then the economy has become more unbalanced.

To be fair to the Bank, the long sweep of history is on the side of a gradual rebalancing; panic is typically not a good policy. However, if we look at the highly similar U.S. economy we see that even with relatively steady growth, localised resource booms, and very high corporate profits, the economy is producing just enough jobs to keep up with population growth.  There has been a structural slowing of job creation over the past decades. Why are Canadian management teams suddenly going to load up on workers at the same time that there is a demand headwind created by the unwinding of a construction bubble?

Thus we return to the main topic: why I think the BoC cannot move too much more before the Fed. If the BoC hikes rates in an environment when the Fed is still trying to talk down the curve, investors will probably pile into the Canadian dollar. A spike in the Canadian dollar puts Canada’s exporters at risk, and import substitution will increase. However, these are exactly the sectors that need to expand to rebalance away from the over-extended “consumer facing” sectors. Therefore, the risk is that even a small move towards tightening could have a massive “cliff effect”: the housing sector cracks, and there are no sectors that will fill the hiring gap. 

I doubt that the Bank analyses the world in exactly this fashion.  However, I suspect that their analysis of the sectoral growth patterns will cause them to be somewhat more cautious than usual, at least as long as inflation is well below the target.

In conclusion: the Bank of Canada can only hike rates at about the same time as the Fed.  If the slowdown seen in Housing Starts continues, it will weaken demand enough that rate hikes could be delayed even further.

(c) Brian Romanchuk 2013

With Summers Out, More Of The Same?

With Larry Summers withdrawing his candidacy for the Fed Chairmanship, it appears more likely that the new Fed Chair will be more gradualist. Janet Yellen appears to be the most likely candidate. However, since it is unclear why exactly the Obama administration passed over the obvious candidate for a more controversial choice, it is possible that they will again propose someone else.

The bond market had a small rally on the news, although this is still not enough to break the technical uptrend in yields. But it still seems likely that a trading range will form somewhere in the general area of 3% on the benchmark 10-year.

I feel that it is unclear that the choice of for the new head of the Fed is extremely critical for the medium-term trend in bond yields. As I have argued earlier, the important economic data are locked into steady trajectories by the automatic stabilisers in the economy. There are no signs of inflationary pressures in the economy; the six-month annualised rate-of-change of hourly wages is only 1.7%, which is a level only previously seen briefly after recessions.

There are very few scenarios that would allow a Fed Chair to convince the rest of the committee to hike rates on a time frame of less than 12 months. It is clear the Quantitative Easing will be disposed of in a gradual fashion, as it was unpopular and ineffective. However, the bar for hiking rates is set higher, and it is unclear that the fall in the unemployment rate will be enough to convince the committee as a whole that the labour market is really tightening. A gradualist candidate will be even more likely to wait to see that inflationary pressures are appearing before hiking rates.

Eurodollar futures contract are now (roughly) discounting a 1% 3-month rate hitting in June 2015. Even if we add in corrections for the difference between the underlying rate in this contract and fed funds, it still indicates that market expectations already incorporate the scenario of rate hikes starting in the first half of 2015. For this reason, there are fundamental valuation reasons to expect stabilisation in yields somewhere in the ballpark of current levels.

 
(c) Brian Romanchuk 2013

Why The Canadian Economy Is Doomed...

The above chart summarises the underlying problem facing policymakers in Canada: construction jobs have become too large a portion of the economy.

There has been a lot of discussion of the Canadian housing bubble. However, house prices are not really the problem; the vulnerability of the economy is via the labour market. Too many housing units are being constructed, and construction workers will be shed as this winds down. The job market in Canada, as is the case in the United States, has become structurally sclerotic. The annual growth rate of the total number of jobs (in all sectors) has not been able to break above 2%, despite the seriousness of the downturn in 2009. As such, it is unclear whether the job market can absorb a serious outflow out of the construction trades (as well as other sectors that have ridden the housing bubble, like Retail).

Although the Canadian economy is stereotypically related to the extraction industries (fishing, forestry, mining, oil and gas), the employment in these sectors is very small relative to Construction or Retail. Commodities are very important for the Canadian dollar and stock market, but they have too small a footprint on the domestic labour market to overcome the potential job losses as the construction market cools. Domestic interest rates will be following these labour market trends.

I will be covering this subject in more detail in upcoming posts. (Why the economy has not yet blown up.)

(c) Brian Romanchuk 2013