Bank of Canada Still Playing Catch-Up

The good news is that the Bank of Canada today matched the maximum market expectation of them, a half point cut in the target for the overnight rate. They even suggested that further interest rate cuts are in store. “Further monetary stimulus is likely to be required in the near term to keep aggregate supply and demand in balance and to achieve the 2 per cent inflation target over the medium term.” Newly-appointed Governor Carney is off to a good start.
The soundly-based reasons for this rate decision were clearly stated by the Bank as follows:

“Canada’s net exports weakened further in the fourth quarter, reflecting the slowing U.S. economy and the impact of the past appreciation of the Canadian dollar….. there are clear signs that the U.S. economy is likely to experience a deeper and more prolonged slowdown than had been projected in January. This stems from further weakening in the residential housing market, which is adversely affecting other sectors of the U.S. economy and contributing to further tightening in credit conditions. The deterioration in economic and financial conditions in the United States can be expected to have significant spillover effects on the global economy. These developments suggest that important downside risks to Canada’s economic outlook that were identified in the MPRU are materializing and, in some respects, intensifying.

The Bank now judges that the balance of risks around its January projection for inflation has clearly shifted to the downside, and, as a result, the Bank is lowering the target for the overnight rate.”
That said, with the Canadian dollar currently trading at above parity, with the balance of payments on current account now in deficit due to slumping manufacturing and forestry exports, and with core inflation running at a very subdued 1.4% in January, a half point cut was the minimum needed.

To put it in context, the Bank of Canada has now cut interest rates by  three quarters of a percentage point this year and by one percentage point since last September, while the US Federal Reserve cut its policy rate by 1.25 percentage points in January alone , and has cut rates by fully 2.25 percentage point since last September. To be sure the US economic outlook is worse than that of Canada, but the Bank of Canada has not cut by enough to close a widening Canada-US interest rate differential which supports an over-valued exchange rate.

Reading between the lines, the Bank of Canada will likely match future US rate cuts. But they still seem remarkably comfortable with a dollar at parity, reasoning that a fast-slowing export sector is needed to take some of the steam out of a domestic economy which they still think is running above capacity. The problem is that the structural damage to export industries is likley to be permanent, and hardly justified by a non existent inflation problem.

11 comments

  • Andrew some questions.

    Do you think that even if Canada matched US interests rates that we would see a significantly lower CDN Dollar. That is do you think interest rate spreads are primarily what is determining the value of the CDN dollar at this time?

    Second do you think that monetary stimulus is going to serve to insulate Canada from the US?

    Third what macro-model are you implicitly using to guide your analysis?

  • I think the interest rate spread does have some influence on the bilateral exchange rate. By memory, it explains 10-15% of the relative exchange rate according to the Bank of Canada econometric model (which does give far greater weight to commodity prices.) The Canadian dollar exchange rate is primarily driven by the commodity price boom (and related financial sector flows) and by US dollar weakness, but I think domestic monetary policy does play a modest role at the margin. Similarly, Canadian monetary policy cannot insulate us from a US recession, but could provide some small cushion.

  • So at best matching interest rates would give us an .85 cent dollar. Would that size of a competitive devaluation be enough to capture market share in the face of a contracting market south of the border?

    I am asking these questions because it strikes me that sooner or later Canada’s problem is going to shift from an external demand problem into or along side of an internal demand problem. Both tax and interest rate policies, given workers are already over leveraged, are unlikely to have much effect on demand.

    If corporate Canada is faced both with shrinking external and internal demand it does not really matter how much cash they have on hand. They are simply not going to expand investment.

    That leaves fiscal policy of a fairly significant magnitude .

    I know there are a lot of what ifs here.

  • Well, Travis, I see today (Wednesday) the dollar jumped by 1 cent despite yesterday’s unexpectedly large rate cut, which seems to vindicate your line of thought as opposed to mine.

  • I wanted to ask Travis what econometric model he is using. Can one really model speculation. Maybe in the short run, but in the long run, all those super computing day traders, no matter how complicated the model, simply fall flat on there behinds, especially when the watering hole finally dries out and the white in the eyes of a spooked herd permeates even the promising light of the strongest beliefs in rationality is lost in the thunder of hooves making a run for the next watering hole. Modeling that is a bit complicated I would think. We just need to get them to run away from the Canadian dollar watering hole. Destabilizing that irrational rationality is the key

    There are methods for cooling off the dollar, but you are not going to be guided by conventional theory. Just like the run up in the dollar, it is not rationally based. Potentially some of the initial causality was, but now some specter more mightier than invisible hands is bouncing our dollar around with blind abandon. This damaging irrationalness is going to cost us dearly. Give me some rationality and then lets talk about models.

    And please don’t say that somehow the price of oil and commodities being linked to the pricing of our dollar is somehow a justification for raising the cost of doing business ion Canada by over 40% in just a short 12 month period is rational and somehow modeled.

    pt.

  • Hi Paul,

    I asked Andrew about which macro-model he was using to get some sense of which aggregates and relationships he thought were most relevant. It need not have been a tight mathematical model.

    I don’t work with any tightly specified model per se. If I had to choose a macro-model it would probably be something of the Goodwin vintage. It is a good place to heuristically start mostly because the model allows for dynamic order in and through disorder. The relevant aggregates would be profits and investment rates, labour supply and capacity utilization.

    Sentiment can be inferred from where one thinks they are on the cyclical curve and which point on the long term cyclical curve one thinks they are on. I will put up a graph on my blog to illustrate this.

    On the exchange rate. I think two factors dominate my thinking. First, the CDN exchange rate was too low for too long. We had several years of surplus budgets, a declining national debt, and a healthy surplus on the trade account. Second the US dollar was overvalued for for too long: they only had a couple of years of surplus, have run large budget deficits and have been running a trade deficit +/- 5% of GDP for a long time. The only thing covering the US dollar was the willingness of foreigners to invest in US assets. As the US economy began to tank and the role of the US consumer as the global consumer of last resort came into doubt the value of the US dollar was bound to decline. As investors scrambled to diversify out of the US markets and the US dollar other national currencies got bid up relative to the US dollar. Now add the bubble in commodity prices (partly explained by the scramble to find a safe haven from a declining US dollar and Voila you have a high Canadian dollar relative to the US that partly respects fundamentals and partly respects reality.

    But the point I was debating with Andrew was simply this:

    Forget about all the forces driving the relative exchange rates between the US and Canada in the present conjuncture and assume that the CB could pick an .85 CDN dollar by matching interest rates. Do you think that in the face of declining demand in the US that a low dollar would have much effect on exports to the US? I think the answer is no.

    The next stage in this crisis is bursting of the present commodity bubble.

  • Hi Travis,

    I don’t dispute the macro dynamics you speak of. I do agree that the Canadian economy had performed reasonable well from the mid-’90s. (take away some equality issues). And in a rational sense the dollar, given the US dollar may have been somewhat undervalued.

    the key point that I would focus on that upsets the apple cart on this seemingly rational argument is the absurdity of the time frame. To go through the kind of shocks that we have due to rise in the dollar in these short spaces is not what I would expect to fall within any reasonable argument. These forces are nothing short of is completely destructive and if this is the way they are supposed to work, then I just see no logic in making some kind of market efficiency argument.

    I would say that I do get carried away with my stories from the herd. However, my point is that after spending so many years within the numbers, I have discovered that the qualitative now is just as important in explaining or rationalizing a subject matter than the quantitative. Of course within a field such as economics, is has always been this fine balance between the two.

    I do not agree with your point on the separation between the two interest rates. If we could get an $0.85 we would not see the pressure as much on the all important auto sector.

    There is a whole pile of assets of that industry that lay on our side of the border, and given the bulls%&t 2 tiered agreement that the UAW has negotiated with the Big 3, combined with the high dollar, the declining markets and we have our largest export branch plant industry totally exposed. Removing the dollar differential would undoubtedly go a long way in preserving a good portion of the assets in Canada. People are still going to buy cars and there will be a good chunk that are produced in North America. The question is where will they be produced given declining demand and the excess capacity. These asset reduction decisions will be made and the consequences will be long term.

    You do raise an interesting corollary. At what level should the dollar be targeted? Where is the point that would allow our assets and workforces to compete given the differentials that have been built into the economic fabric over the past 20 years within most of our manufacturing industries. Yes we could slowly adjust to a higher dollar but not within the timeframe that has usurped our dollar valuation process.

    These are tumultuous times, and resting within the warmth of some comforting neoclassical theory is not the way to proceed. We need to look back towards our history with a wider focus to see what may be helpful.

    I also agree the bursting of the commodity bubble is next up. However, this one is a bit different. It is almost similar to the abandoning of the gold standard way back in the ’20s. We need something to take the valuation process of different currencies from the jaws of speculative processes. It’s not a new problem. The EU did a pretty good job of regionally taking those smaller currencies out of such processes. Not sure if we could ever do that in North America, the US would never surrender to such power sharing. The EU did not have such an asymmetrical problem when it comes to power sharing. (Germany potentially has a bit more clout than most countries, but not to the degree the US has in our region).

    Thank you for your reply.

  • Hi Paul,

    I too think the rapidity of the appreciation shows just how unpredictable and jarring economic changes can be. A far cry from the timeless and frictionless GE models to be sure—but everybody knows those models are junk science. What I was arguing was that yes I think the sudden appreciation was absurd given the time frame but not absurd if it had happened slowly over the last 6 years for the reasons I set out.

    I am not a quant by the way.

    As for and .85 cent dollar and autos, that is way out of my league to guesstimate. Although, Hargrove has been focusing on access to other foreign markets as the real problem facing autos. So there are two problems here. One is the value of the CDN dollar and the other is the state of the big three and their perpetually declining market share.

    This is not to say that high dollar has not hurt manufacturing in general or autos in particular. Clearly it has.

    By way of conclusion, I am not a neoclassical. I have never met a stable full employment equilibrium in my life. Hence the Goodwin vintage models.

  • Not a problem, I didn’t mean to insult you in such a way as to infer that you were a neoclassical, if I came across as that then I apologize.

    Heard some interesting rumours today that made me stop and think about the disaster that could be lurking up ahead.

    Lets say that the speculative linkage is now in place with commodities and our dollar valuation. Well there has been a lot of talk of late that two things could be on the horizon that could make our discussion here seem a bit ridiculous.

    First there is rumour that the US dollar could devalue by at least another third when compared against OIL. There was also another rumour that oil could hit 150 a barrel with similar upside pressures on other commodities (especially gold).

    Not sure if we are talking about a half a dozen of one or the other, but either way if we have another one third rise in our dollar, our current height last fall of 1.10 could be just a precursor of what is coming. And is not a long of a shot that some might think by any means that we could see a Cdn $ at 1.30 or more in the future. I even heard as high as 1.50 today. Can you imagine what that would do to us.

    We are messing around with keeping it under 1.00 but what if the lid comes off. I am know there are some measures the BoC can implement but given the crowd on the hill makes me wonder.

    I have just been finalizing a report on the forestry sector, and quite simply the rising of the dollar has been the defacto- root of an unprecedented restructuring within the industry. Basically the carnage has focused on the small to medium enterprises. It has seriously effected the larger, and it is now a race of time. Who can withstand the adjustment period. There are new markets/products and efficiencies that offer hope to the larger firms and the odd innovative sme’s. However any rate increase like that noted above and given the credit crunch we are currently facing, we could see some quick exits out of Canada of even the larger players.

    Again back to the point, why is this irrationalness, at the heart of the issue, held up by the neoclassical schools as some kind of rationality. There competitiveness notion is so far away from the root causality that I am not even sure it is even a relevant part of the argument any longer.

    The more we get lost within the swirling arguments the more amazed I am that it all has some how stuck together this long. But I guess when you use such a large sludge hammer that capitalism does, then it can take quite a bit for it to come flying apart. While the fences are coming apart at every nail right now.

    pt.

  • Wow ! What a great exchange of comments above . There should be more of this as that would advance the understanding of all of us that either participate or just read all that is written .
    But how do you get the Harperite’s to read this – they sure need to learn something about economics .

    As an Exporter , I would welcome an .85 cent dollar , but I don’t see that happening any time soon . Personally I see the U S dollar dropping further , and that will raise the Cdn dollar relative to the US – and 1.50 would bring Canada to a near standstill in the short term. We don’t sell enough to other countries to keep our manufacturing going any where near economic factory use . The Canadian auto sector will close for awhile .
    In relation to other major world currencies , our dollar won’t change a whole lot , and might even drop if the US dollar drops another 15% . But we don’t export enough to compensate for the loss of the U S markets .
    If the U S recession lasts more than 12 months , the Canadian economy will be changed forever . The hardship will be enormous , especially if someone wacks the economy at the same time with a high carbon tax that will most affect consumers that are out of work . I wouldn’t want to live in Southern Ontario during these times .
    My business is lucky at this time – I can move out of Canada , buy product in U S dollars and resell it in Euros or some other still strong currency . I don’t have much physical plant in Canada as government policies in recent years discouraged me from building in Canada . But the outlook is grim for those that have a large investment in plant in Canada .

  • All else equal I’d like to see a Canadian dollar at 9999999 cents US.
    Saw Mark Carney interviewed on CBC today. He was asked about inflation targets and mentioned he was mildly considering the idea of decreasing the 2% annual inflation target slightly, to aid the increasing number of seniors on fixed incomes. He also mentioned he thought public imput would be useful without specifying a forum, so I figure I’ll throw down my viewpoint here before I forget:

    I view inflation targets set by monetary policy as a tool to either reinforce existing and expected liquid capital ownership, or to junk existing capital piles.
    That is, the more mature and “adapted to quality-of-living” given liquid capital allocation are, the lower one would want inflation targets to be; they could even be negative. The more capital allocations are divied up in a way that does not reflect existing and expected qualities-of-living (paying University students to hammer nails in their arms or making Absynthe cheaper than baby formulae). If some tyrant got a majority government in Canada and began passing very foolish economic legislation despite the Senate and the Queen, higher inflation would be one way of diluting the harmful effects. If we got a government that magically acted in a way to raise life expectancy and quality-of-living of Canada and the world, we’d want to butress whatever they are doing right in the monentary policy arena by lowering inflation targets (I think).
    As it is, Canada’s monetary policy and financial systems look above average vis a vis the world, but that is likely only because much of the world fell prey to neoconservatism over the past three decades.
    M.Carney mentioned pension incomes as a reason to lower inflation targets (so the incomes of increasing #’s of pensioners won’t be further eroded), but a much more pressing capital horde to me is the uber rich. We are starting to see US-style political control excercised by the very wealthy in Canada. Not necessarily an evil thing; people need carrots to be uber productive. Paying good physicians and good engineers good salaries is no problem, but pareto effects mean “average skilled” people who have obtained cash by reasons other than professional merit, get the carrots of the rich. So some tempering is needed to guard against this effect. In my view, inflating away their net worths a little could be this tool if it isn’t politically feasible to raise top-tier income tax rates.
    Also, over time, more portions of the economy will likely prove deflationary (consumer electronics) than inflationary (cost of fresh water, cost of seawall erosion mitigation), so inflation should naturally trend downwards, notwisthstanding demographics. Go Jets.

Leave a Reply

Your email address will not be published.