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Latest Healthy Economic Numbers
February 26, 2010
There has been much to digest since the last Bank of Canada decision, though little to motivate a major change to the monetary policy outlook. Central bank speakers have filled the calendar like never before, however none managed to reveal anything profoundly new on the outlook for monetary policy. The latest healthy economic numbers have burnished Canada’s image, but the outlook remains broadly in line with past estimates. Recent European fiscal concerns have failed to leave a significant mark on Canadian financial markets or the Canadian economy. And recent U.S. exit strategy revelations have only limited relevance for Canada – a country that avoided quantitative easing.
Canada has certainly enjoyed a string of healthy economic reports. Fourth quarter GDP is now on track for at least a 4% annualized growth rate, which will modestly exceed the Bank of Canada’s forecast. Similarly, Canada’s labour market has managed to churn out yet more jobs, and the pace has shifted from a trot to a canter. Canadian total CPI is now up to 1.9% Y/Y, and core CPI has suddenly leapt to 2.0% Y/Y.
Despite initial appearances, none of this screams for higher interest rates – at least not quite yet. Outsized economic growth in Canada is at least in part a function of lumpy
stimulus and inventory contributions, both of which will begin to fade. Growth is unlikely to be quite as fast in 2010. Relative to the U.S., Canada will have lagged in both the third and fourth quarters of 2009. Labour market strength is unquestionably impressive, but the unemployment rate remains quite high and wage pressure is declining. And the core inflation reading will struggle to persist,
let alone advance, as we discuss more fully later. There is no question that Canada’s economy – especially the domestic-facing side – has a rosy glow about it. But the devastation of the credit crunch was enough that only the brawniest of countries should consider removing monetary stimulus quite yet.
There are two parts of the Canadian economy that merit further discussion given the context of monetary policy. These are housing and inflation.
Hold Your Housing
Hawkish market-watchers have long argued that the Bank of Canada must promptly reverse its stimulus so as to quell housing market strength. Canadian existing home prices continue to rise by close to 20% per year, and other measures show robust monthly gains, if not the same astonishing annual advance. TD has always believed the market would likely sort itself out as the overhang of buyers begins to fade and as listings rise.
Regardless, the housing issue is now suddenly off the table. What’s more, the Bank of Canada can say “I told you so”, as it has argued all along that a solution to Canada’s housing strength should come through regulatory channels, not monetary ones. This is what has happened. The Department of Finance has instituted new rules that will reduce speculation, limit buyers who might be unable to afford payments in a rising rate environment, and cap the amount of equity withdrawal. It is an open question whether these specific steps will be enough to cool Canada’s housing to a more sustainable growth rate, but that is not the point. What matters is that a precedent has been set and any further issues with housing strength will more likely than not be handled via additional regulatory measures, rather than monetary policy. The Bank of Canada is free to focus on more traditional considerations.
Inflation’s Revival
Inflation certainly qualifies as a traditional consideration. Canada’s recent inflation heat comes mostly as a surprise. A core CPI reading of +2.0% Y/Y defies significant economic slack, low (and slightly declining) inflation expectations according to the Business Outlook Survey, the strong Canadian dollar, and an absence of quantitative easing in Canada.
The good news is that further strength is unlikely. Although Governor Carney recently cited persistent wage growth as a possible explanation for recent core inflation strength (wage growth is slow on an absolute basis but has substantially exceeded productivity growth), the Bank is clear in its observation that wage growth “has decelerated in recent months” and should “moderate overall pressures on core consumer price inflation.” Base effects will shortly shave a few tenths off the top of core CPI, as auto and agriculture strength fades. Recent core strength has also lacked the sort of breadth that might otherwise keep central banks up at night, though it is true that TD’s three alternate measures of core inflation have also drifted upwards, albeit averaging a more constrained +1.8% Y/Y.
The best way to think about Canadian inflation is that it is running sufficiently contrary to expectations that it merits further watching, and presents a risk to the outlook for monetary policy. If upward pressure continues to persist for a few more months, the Bank of Canada might be forced to reconsider its stance. But until then, it is important to recognize that even an inflation-targeting central bank does not set policy based on current inflation, but rather upon anticipated inflation one to two years down the line. The best guide for this is not inflation itself, but instead the amount of economic slack in the economy. Barring a significant re-imagining of the output gap, the unemployment rate, and capacity utilization, considerable slack exists.
They Kept It Simple
For all of their similarities, Canadian and U.S. monetary policy are substantially different. The U.S. engaged in quantitative easing, and so it is now forced to lay out a complicated multi-step exit policy. Canada did not, and so has a much simpler task.
Because of this, there is much less to speculate about for Canada. There is no significant reserve balance reduction necessary for Canada, so that step can be mostly skipped. Similarly, there were no major assets purchased by the central bank, so no unwind is necessary. Even the rate hiking sequence will be simpler, as Canada can afford to continue focusing on its traditional guide – the overnight rate – instead of temporarily switching to more esoteric implements as in the U.S. case.
Canada’s communication policy will also require fewer aspirins. The Bank of Canada gambled when it instituted an explicit conditional commitment not to raise interest rates before mid-2010. Had the Bank of Canada been forced to violate this commitment, it would have done significant and lasting damage to its credibility. Fortunately, this gamble has been won, as it now appears that the Bank will be able to meet its commitment. Suddenly, the shoe is on the other foot. Whereas the Bank of Canada took all of its risks up front with the benefit that the market now knows precisely when hiking could conceivably begin, the U.S. used a rolling (and vague) “extended period” commitment that left it with significant wiggle room at the beginning, but now has a communications problem that will require some fancy footwork to escape from without confusing markets.
To be sure, there is a touch more than just the usual rate hikes that will be needed to return Canadian monetary policy to normal, but by and large these changes have been made. Liquidity programs have mostly expired and the last vestiges of special programs wind down by mid-year. In Canada, asset purchase programs were implemented by the fiscal arm instead of the monetary arm. They were funded with debt instead of a printing press, and the ABS and mortgage purchase programs both appear set to expire by the end of March, with further confirmation in the upcoming federal budget on March 4th. Assets will likely roll off naturally as they mature. This will have only mild and gradual implications for credit spreads, and nothing whatsoever for the money supply. None of this is under the Bank of Canada’s purview, nor is it of high relevance to Canadian monetary policy.
Parsing the Text
The coming Bank of Canada communiqué should be shorter and less revelatory, mainly because it is not paired with a Monetary Policy Report. This means that no new economic forecast will be offered, trimming a few paragraphs off the length. And although economic developments have been reasonably good, it is unlikely that the Bank will change its wording substantially, or stray from its statement that “the underlying macroeconomic risks to the projection are roughly balanced.” It is tempting to think the additional clause that “the overall risks to its inflation projection are tilted slightly to the downside” might be excised, but so long as the overnight rate remains at its effective lower bound and the economic assessment is “balanced”, this probably remains.
Inflation should continue to be projected to return to target in the third quarter of 2011, and the output gap should remain in the 3-4% range.
Global fiscal concerns probably do not figure explicitly into the statement, and the Canadian dollar should again play only a bit role in the discussion, given that it is slightly softer than the assumption used in the Bank’s economic forecasts. Upside and downside risks probably remain unchanged, though internally the Bank of Canada may believe that the composition of downside risks has shifted such that Canadian dollar strength is becoming less of a concern while the possibility of a more protracted global recovery is becoming more worrying.
The conditional commitment to leave the overnight rate unchanged through to the end of Q2 2010 should remain, and it would be truly shocking if it were omitted. The Bank of Canada may eventually wish to provide a bit more guidance for markets, but it would be premature to do this before the April or June decisions.
Medium Term Outlook
Beyond the coming rate decision, the Bank of Canada has a few decisions to make on its way to what we anticipate will be a first rate hike in Q4 2010. Even though it has deftly handled its conditional commitment through to mid-2010, there is nonetheless a bit of stick-handling left to be done. In the absence of any additional communication from the Bank of Canada, the market may be inclined to think that the July 20th rate decision will unveil a first hike. If the Bank of Canada wishes to short-circuit this expectation, it will need to give a signal. That signal is likely at the April or June decisions, and may come in the form of something akin to “some removal of monetary stimulus will be necessary over time”), indicating a disinclination for immediate hikes while confirming that hikes are not too far off, yet maintaining some flexibility.
The other minor communications challenge is that the Bank of Canada will wish to emphasize to the market that – even once it has begun raising rates – policy rates will continue to offer considerable stimulus to the economy. The level matters, too. This is a subject unlikely to be confronted for several more meetings.
TD continues to believe that the Bank of Canada will raise rates before the U.S. Federal Reserve, partly because the economic recovery should be somewhat more robust in Canada, and partly because in the absence of alternate policy tools to remove, the Bank of Canada’s first step will be rate hikes, whereas that will only be the Fed’s second major action.
R.Paul Chadwick
TDCanada Trust
Manager Residential Mortgages
Tel: 905 334 4066
Fax: 905 332 1619
paul.chadwick@td.com
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