Rate hikes & Conflicts of Interest

Arun DuBois signing in after a long absence. I’m breaking radio silence because (a) I suddenly have a bit more free time (how do the rest of you do it? You folks are machines!); and (b) my righteous indignation has been stoked to full throttle this week after reading one too many Globe and Mail story quoting seemingly disinterested financial-sector economists/commentators urging or insisting on one or both of the following:

(i) that the Bank of Canada MUST gun interest rates higher because of our abysmal productivity records and the threat that we might push the economy beyond its capacity; and

( ii) that the Canadian dollar is going to spike higher and yes, parity with the U.S. is just around the corner.

Now it doesn’t take a conspiracy theorist or even a progressive economists to see that a lot of this talk may be motivated by self-interest. I’m willing to bet that at least some of these folks are “talking up the market” to benefit the books of their employers who may have bet on a rising (or falling) dollar.

The rationale is simple: if enough people say it and enough believe it, “it” often is. Currency traders, bank economists, fund managers, and the rest understand this better than most, which is why many if not most of these institutions appoint “designated hitters” to field routine media requests. When I was a financial journalist way back when, we called these people our “dial-a-quote” sources : always available, ever dependable, and always ready with a catchy quip around which to build a story.

I really can’t blame the financial-sector folks for doing their psychopathic best to generate profits for themselves, their loved ones, and their beloved employers. It’s the journalists who, it seems to me, are failing us, the reading public. They’re the ones who, at least nominally, operate under some larger sense of mission of informing the public in something approaching an objective rendering of the world around us.

Now lest any journalist recite the usual litany of challenges they face in the daily grind, let me just say that yes, I understand more than most the constraints of the job, and I’m sure I wasn’t always purer than snow on this way back when, but is it really too much to ask to throw in a line suggesting that the source in question might work for an institution that has a direct financial interest in the outcome of the Bank of Canada deliberations? The place I used to work for had policies around this. Imperfectly applied sure but nevertheless.

Here are some examples of what I mean, with my comments in bold:


THE DOLLAR SOARS Traders place their bets on loonie Long positions jump to a record high

HEATHER SCOFFIELD ECONOMICS REPORTER Currency traders are betting overwhelmingly that the Canadian dollar will continue its climb toward parity with the U.S. dollar, after it closed above 92 cents (U.S.) for the first time in almost 30 years. Economists, however, disagree about whether the loonie can sustain its run.The dissenting economist in question — see below — doesn’t work for a financial institution with positions in the market and so has less of a vested interest in selling the “dollar-going-to-parity” story. While we’re on the topic, it’s always fascinating to watch journalists set up stories as vast conflicts (“economists disagree”) even though they’ve talked to, at most, two sources.

Total long positions on the Canadian dollar jumped last week to a record high, and net long positions (weighing long positions versus shorts) were at their highest in 15 months, data from the U.S. futures market show.

The Canadian dollar closed yesterday at 92.08 cents, up from 91.79 cents on Friday, according to official Bank of Canada data. It’s the first time since October, 1977, that it has closed above 92 cents.

“The Canadian dollar has set a new-generation high, and now the market has parity and beyond firmly in its sights, supported by an ongoing global economic expansion and upward pressure on commodity prices,” said John Johnston, chief strategist at RBC Dominion Securities’ Harbour Group in Toronto

Suggested journalist question : what’s your position on the C$ John?

But the confidence among currency speculators is not shared by all economists.

A dissection of the long-term movements in the Canadian dollar by Global Insight (Canada) suggests the loonie’s recent surge is transient. Chief economist Dale Orr projects the Canadian dollar will average 87.9 cents this year, which is actually slightly lower than the 2006 average of 88.2 cents.

“We are forecasting that most of the appreciation of the Canadian dollar we have been experiencing, not only in recent months, but since 2002, is now behind us,” Mr. Orr writes in a paper to be released today.

Traders cite last week’s blockbuster economic data as evidence the Canadian dollar should continue to appreciate.

They point to retail sales, manufacturing output, wholesale trade, as well as frenetic merger and acquisition activity.

But the long-term trends in the currency are linked more to how the U.S. dollar is faring internationally, the global price of commodities, and the spread between U.S. and Canadian rates, Mr. Orr argues.

He calculates that about 40 per cent of the rise of the Canadian dollar from a low point of 84.6 cents in early March to today’s levels above 92 cents is due to the weakening of the U.S. dollar against other currencies. Generally, the euro, the British pound and other currencies have been appreciating, too.

The Canadian dollar has appreciated more than those other currencies, but much of that surge can be traced to commodities. Oil rose 2.5 per cent between March and mid-May, and gold was up about 3 per cent. Copper, nickel and uranium were up 30 per cent.

And the Canadian currency is also benefiting from a belief that the interest rate spread between Canada and the U.S. will soon narrow or even disappear. For now, the key U.S. interest rate is 100 basis points (one full percentage point) above Canada’s 4.25 per cent.

But with the U.S. economy weakening, many analysts believe the U.S.

Federal Reserve Board will cut rates once or twice this year.

And with inflation in Canada bubbling over and growth on a solid track, economists and market players believe the Bank of Canada will raise rates once or twice by the end of the year. The bank’s Governor, David Dodgefed that perception on Monday when he told reporters he was keeping a close watch on inflation.

Mr. Orr sees a Canadian dollar trading in a range between 87 and 91 cents. That’s because he thinks commodity prices will likely stabilize, the U.S. dollar will steady, and the markets have already factored in Canada-U.S. interest rate convergence.

Like Global Insight, many economists are in the midst of rethinking their expectations for their currency.

“Our forecast is in flux,” says Avery Shenfeld, economist at CIBC World Markets. While markets have factored in some expectation of rate convergence, the dollar could well climb further as the anticipation becomes a reality, he said.”The currency can go anywhere in the short run,” he said. “The real question is, what can we live with?”

ITEM 2, GLOBE & MAIL, MAY 30, 2007

INTEREST RATES: THE 1970S REDUX High-flying economy catches bank off guard Inflation risk fuelled by soaring loonie, high house prices and low jobless numbers

TAVIA GRANT The Bank of Canadahas issued a stark warning that interest rates may rise as the era of benign inflation ends, a statement that sent the loonie rocketing past the 93-cent (U.S.) mark for the first time in nearly three decades yesterday.

It’s been a remarkable ride for the Canadian economy in recent months, one that’s taken virtually everyone by surprise. The unemployment rate is at a 33-year low as a record number of Canadians have jobs.

Exports have stayed strong, despite a slowdown south of the border, as companies beef up trade with Europe and Asia. Closer to home, so to speak, Canadian house prices and sales set records last month, a report said yesterday.

That economic growth has been accompanied by little sign of price pressure – until now. Core inflation – without the most volatile items among consumer prices – is running at a four-year high amid rising home and food costs.

“This is clearly the stuff of rate hikes,” said Marc Levesque, chief economics strategist at TD Securities Inc., who expects the trendsetting rate to rise in July and again in September

Suggested journalist question: what’s your position on the C$ Marc?

“Core inflation is running ahead of the Bank of Canada’s target – and systemically so. That alone raises a big red flag.” But there are other red flags too, namely the astonishingly swift ascent of the Canadian dollar. The loonie’s gained almost 9 per cent this year alone against its U.S. counterpart and has surged 43 per cent in the past five years.

In anticipation of a rate increase, Canada’s major banks raised their posted mortgage rates by nearly one-third of a point yesterday.

Rising interest rates will make the currency even more alluring to international investors and could well drive the loonie to approach parity, economists said.

If that happens, “it’s going to mean huge pain and directly lead to some plant closures and layoffs,” said Avrim Lazar, president and chief executive of the Forest Products Association of Canada, whose industry has about a million direct and indirect employees.

That pain was noted in Ottawa yesterday. Industry Minister Maxime Bernier acknowledged that the loonie is a “concern” for Canadian industry, saying it’s vital that the government has policies to help business compete, Reuters reported.

For every penny the loonie rises, it sucks about $500-million from Canada’s forestry industry in terms of increased losses, “so of course we’re not enthusiastic,” Mr. Lazar said.

The Bank of Canada sets its overnight rate by focusing on keeping inflation low, regardless of currency levels. It’s an approach that Mr. Lazar says is “a policy error, because that’s not the only measure of society.” That approach has, however, kept inflation near the central bank’s 2-per-cent target throughout Governor David Dodge’s seven-year term and helped Canada weather years of economic ups and downs.

Now, inflation threats may prompt the central bank to act. More evidence of a hot economy landed yesterday, with a Canadian Real Estate Association report showing average resale home prices jumped 9.3 per cent in April from a year ago, topping the $300,000 mark for the first time.

“There is an increased risk that future inflation will persist above the 2-per-cent inflation target and that some increase in the target for the overnight rate may be required in the near term to bring inflation back to the target,” the bank said in its statement, while leaving the rate unchanged at 4.25 per cent for now.

There’s plenty of debate over when the move may be. Many economists are expecting a rise at the bank’s next meeting in July; others say it may wait until September.

“It’s not 110 per cent sure we’ll see rate hikes in July . . .

I think that’s where investors should be very cautious,” said Sebastien Lavoie, an economist at Laurentian Bank in Montreal, who believes a slowing U.S. economy could still sting Canada

Suggested journalistic line of inquiry: Is Laurentian Bank betting on a weakening currency?

He noted the bank’s statement said rates “may” – not will – increase, careful wording that may reflect how hotly contested yesterday’s announcement may have been among central bank officials.

“There is definitely a very interesting debate within the Bank of Canada walls right now,” he said. He ought to know: He spent three years in those walls as an economist with the central bank.

ITEM 3 (my favourite) — GLOBE AND MAIL, May 29

Economics: Get ready for rate hikes, slower growth. Productivity gap will force Bank of Canada’s hand, leading economist warns

HEATHER SCOFFIELD ECONOMICS REPORTER Canada should brace for an era of slower growth and higher interest rates in response to a poor productivity record that is taking a serious toll on the economy’s potential, warns economist Don

Snarky aside: Don, as a former senior Finance Official, adds a little more economic substance to his argument than his competition. Call it “value-added” but it’s only of the cheap, “built in a (bad) economics 101 factory,” kind.

The central bank is not expected to raise rates today, but market players and economists believe it will act some time this year.

And Mr. Drummond, chief economist at Toronto-Dominion Bank, predicts the move higher will come soon, this summer, despite the recent appreciation of the Canadian dollar.

It’s a sign of things to come, Mr. Drummond argues.

“Nobody may be expecting the Bank of Canada to raise its interest rate [today],” Mr. Drummond says

Suggested journalist question (again): tell me Don, what’s TD’s position on the C$ and just how solid are those Chinese walls anyway?

“But they would be justified in doing so. And if they don’t act [today], they will need to soon.” Years of sagging productivity growth have meant that the supply side of the economy – its capacity to produce goods and services – is tight, he explains. And so, even economic growth considered mediocre by historical standards can be enough to fuel inflation in today’s productivity-constrained atmosphere.

He sees an era where the most the Canadian economy can grow without fuelling inflation is 2.5 per cent a year. In Central Canada, the speed limit is even lower, around 2 per cent a year.

“It’s sad, really sad,” Mr. Drummond said

Snarky aside: What’s really sad, Don, is the Bank of Canada’s willingness to burn the village in order to save it and the economics’ professions lust for this kind of tough love.

The signs that such an era has begun are all around us, he adds.

Companies across the country complain about labour shortages and capacity restraints. Imports are not as cheap as they were a year ago, driving up prices for food and other goods. Service prices have been climbing quickly. Inflation is rising, and not just in Alberta. The economy, most analysts and the central bank say, is operating in overdrive.

Higher interest rates, analysts say, will be required to keep inflation under control.

But at the same time, the long-term growth pattern of the Canadian economy is hardly inspiring. The first quarter of this year will likely prove to be strong – well above an annualized 3 per cent – and the second quarter is shaping up to be robust, too. But that’s after three successive quarters of an economy close to stagnating, and it’s enough to require the central bank to hit the brakes through interest rate increases.

The old assumption was that the economy could chug along comfortably at a 3-per-cent growth pace every year without stoking inflation.

Over the past 18 months, the central bank has gradually ratcheted down what it believes is the maximum inflation-proof speed for the Canadian economy, and it will dip to about 2.7 per cent a year by 2009.

Snarky aside: NAIRU (and its variants) : the silly theory that never dies.

That means if the economy is poised to grow faster than a 2.7-per-cent pace for a prolonged period, the central bank would be inclined to raise rates to keep growth and inflation in check.

Using the central bank’s own methods, Mr. Drummond calculates that the limit will drop further, to about 2.5 per cent a year for 2008 and 2009. And interest rates will have to climb if growth goes above that pace because the economy does not have the capacity to handle any more.

Productivity is the source of the problem. Canadian companies have not invested enough to increase output, except through adding more labour. Conversely, big improvements in productivity could solve the low-growth-higher-rates conundrum, Mr. Drummond says.

The standard of living in Central Canada in particular depends on such improvements, he adds. Since high energy prices are likely here to stay for a while, Western Canada will grow faster than Central Canada. And with the central bank focused only on keeping overall national growth on a non-inflationary trajectory, Central Canada will likely be faced with higher rates while growth drags along at about 2 per cent a year, Mr. Drummond said.


  • Could you explain to me how I can transform my professional judgment into cold, hard cash? My mortgage payments are going to go up soon, and I’d appreciate any advice about how I can personally profit from thinking that the Bank should increase interest rates in order to keep inflation under control.

  • Stephen,

    Back when you made your last blog post calling for a rate increase, you should have bought forward in the currency markets. With the increase in the C$ as a result of the market’s reaction to the BoC statement, you would already have made money.

    Step two would be to better establish yourself as a leading media commentator on such issues, then create a bank of your own. You may need to find some other investors to pool your risk, and as a result they may compromise your ability to avail yourself of the company jet and other assets, as Conrad has learned. Alas, this is a game for the big boys.

    🙂 See you in Halifax.

  • If the main sources of inflation are supply constraints then there are two remedies: increase productivity or increase productive capacity.

    Increased interest rates only compound the problem by driving up the cost of investment, slowing the pace of real accumulation and starving the economy. A more nuanced approach would be to cheapen the cost of investing in productivity and capacity while depressing demand.

    Of course that would require real government intervention so best stick with interest rates and let the labour market shoulder the cost of adjustment for the macro-economy.

    Hey, that was not a bad definition of neoliberalism come to think of it.

Leave a Reply

Your email address will not be published. Required fields are marked *