Bank of Canada's Policy Flexibility Makes Rate Decision a Coin Flip

Multiple threats to financial stability have made crystal balls cloudier this year.

Does Canada Need Another Rate Cut?

Uncertainty reigns ahead of tomorrow’s Bank of Canada interest rate decision. 

The implied odds of a rate cut according to financial markets stand at just over 50 percent, and private-sector economists are almost evenly divided on whether the nation’s central bank will cut its policy rate to a financial crisis low of 0.25 percent.

But one thing’s for sure, says Avery Shenfeld, chief economist at CIBC World Markets: what the Bank of Canada will project as the headline inflation rate by the end of 2017.

“I’d bet a lunch with anyone that the last CPI number on that [forecast] table is 2 percent," he said. "They always say, conveniently, 'By the last period we'll have done the right thing and the output gap is closed.'" 

That confidence is grounded in what private-sector and academic economists perceive as the Bank of Canada’s reactive function—what prompts it to ease, tighten, or stand pat.

However, the presence of multiple threats to financial stability have made crystal balls cloudier this year. That uncertainty may prompt the central bank to envisage a longer wait until the economy gets back home, as the collapse in oil prices proves to be more severe and persistent than originally thought.

The Bank of Canada has a mandate to keep headline inflation near the midpoint of its 1 to 3 percent target range, and monetary policymakers typically seek to have inflation at this level within six to eight quarters. This timeframe is consistent with the amount of time it takes for a change in policy rates to have its full impact on inflation.

In practice, this inflation-targeting framework means that the central bank is actually targeting a zero output gap: for there to be no cumulative difference between actual GDP growth and potential growth. 

Potential output is best defined as an economy’s cruising speed; the highest level of growth consistent with stable inflation close to a central bank’s given target. Typically, when there is a negative output gap, the monetary policy stance is accommodating in order to help the economy eliminate slack, and vice versa in the event that the economy has been running too hot.

The problem here is that the output gap is an unobservable metric because of the difficulties involved in estimating potential growth. One can drive a Zamboni through the Bank of Canada’s estimates of the output gap, and as such, its usefulness as a real-time indicator for monetary policy, which itself works with long and variable lags, is questionable at best.

Nonetheless, it is the output gap that the Bank of Canada chooses to hang its hat on. During the press conference that followed Stephen Poloz’s first rate decision as governor, he said that “it is the output gap which guides the pressures on inflation through time.”

In that sense, the Bank of Canada’s January 2015 interest cut was proactive, foreseeing a widening of the output gap absent the addition of monetary stimulus following the collapse in oil prices. The July reduction was of a more reactive nature, responding to a drop in activity that turned out to be larger, and ultimately long-lived, than anticipated.

This month, a blend of both dynamics is at play: sluggish fourth-quarter data suggest that there is more economic slack than the Bank of Canada envisioned in October, while declining inflation expectations and subdued hiring plans imply more weakness on the horizon.

Proponents of a rate cut often cite those two factors, among others, as support for action by the Bank of Canada, while opponents of additional easing see two ways a rate cut could destabilize the financial system.

Financial stability concerns are nothing new for the central bank, which maintained a tightening bias until October 2013, in part due to worries over household credit growth and elevated indebtedness. But this is the first time in recent memory that economists see threats from multiple angles.

Recently announced macro-prudential measures alleviate some of the concerns, though a rate cut would undoubtedly put downward pressure on borrowing costs, offsetting some of the forces driving borrowing rates higher.

"Further rate cuts will simply work at cross-purposes with the three-pronged measures to cool the housing market, introduced by Ottawa late last year," wrote Bank of Montreal Chief Economist Douglas Porter and Senior Economist Benjamin Reitzes. "Another rate cut could fan a market with one hand that policymakers are trying to slowly tamp down with the other."

The new threat to financial stability stems from the collapse in the Canadian dollar, whose 25 percent plunge over the past two years marks its worst decline for that time period on record.

The Bank of Canada could be "playing with fire" if it chose to lower rates further and "set off a freefall in the exchange rate," said CIBC's Shenfeld, citing the potential negative effects on confidence and consumers' willingness to spend. Since total spending in an economy is equal to total income, if everyone cut back on expenditures at once, Canada would be adding a household deleveraging process to its current terms of trade shock.

None other than Mark Carney, Poloz's predecessor and current Bank of England chief, recognized the importance of balancing concerns about financial and price stability--and that the two might sometimes be in conflict.

"Central banks are recognizing that they need a deeper understanding of financial system dynamics in order to better understand the relationship between price and financial stability and, ultimately, the contribution of both to the stabilization of economic activity," said Carney in his 2009 speech at the Jackson Hole Symposium. "The main challenge for joint optimization is that financial and price stability share common determinants but have different time horizons."

In theory, a rate cut would help the economy eradicate slack through a stronger performance of net exports and continued strength in interest rate sensitive segments of the economy. Both courses of action risk exacerbating financial vulnerabilities, however.

Poloz is under no obligation to return inflation to target within eight quarters, as is usually the case, and enjoys flexibility in determining the amount of time to get the economy back to normal. If Canadian monetary policymakers judge that the magnitude or nature of an economic shock is such that stimulus is insufficient or ill-suited, they can extend the projection horizon for a return to full health, as they have done several times in the past.

That is, if Poloz is content with the outlook for and composition of growth, there is no mechanical trigger for additional accommodation.

“There are some times where it just isn’t realistic to achieve [a zero output gap and 2 percent inflation] over the projection horizon,” said Bank of Montreal's Porter.

“I think we’re almost at the limits of monetary policy,” said Scotiabank Vice President of Economics Derek Holt. “The nature of the shock—a negative terms of trade shock—presents both cyclical and structural challenges, and given how far we’ve come already in easing monetary policy, I can’t see too much more effectiveness.”

The danger in allowing inflation to remain below target for too long is that inflation expectations can slip, which prevents the optimal transmission of monetary policy in the future and erodes central bank credibility. Financial crises, though rare, can have potentially crippling effects on output and inflation, which is why Canadian monetary policymakers are afforded some latitude in their attempts to avoid one.

"The Bank recognized that because the effects of financial imbalances on output and inflation could manifest themselves over a long period of time, some flexibility might be needed with regard to the time horizon," reads the backgrounder for the central bank's most recent renewal agreement. "While this flexibility might involve sacrificing some inflation performance over the usual policy horizon, it would lead to greater financial, economic and, ultimately, price stability over a somewhat longer horizon."

The governor urged patience on economic progress in his last public appearance prior to Wednesday's decision.

"It typically takes three or five years to adjust to a significant shift in your terms of trade, which is what we're going through," Poloz told reporters following a Jan. 7 speech.

On one hand, this statement could suggest that Poloz believes the Canadian economy will require support from monetary policymakers throughout this adjustment process--a period that runs far longer than the central bank's typical forecast horizon.

“If you go back to Poloz's point in the Jan. 7 speech about an adjustment period of 3 to 5 years [from the oil shock], that length of time for the adjustment could suggest that monetary policy may not be the ideal instrument for aiding that adjustment,” said Brian DePratto, economist at Toronto-Dominion Bank. “It might fall outside the scope.”

Carleton University Professor of Economics Nicholas Rowe, however, notes that there is another way to interpret this statement, which implies that excess capacity is not building up amid this transition.

“If you get hit by a real shock that required resources to be re-allocated from, say, Alberta to Windsor, then even if you kept inflation at 2 percent exactly, in the face of that real shock, output would drop temporarily and unemployment would go up temporarily as resources took time to be reallocated,” said Rowe. “Potential output would temporarily drop below what it otherwise would have been.”

While private sector economists often note Poloz's predilection for easier monetary policy, the risk management framework championed by the governor actually argues for inaction--a 'do no harm' approach.

"The essence of this framework is that acting to reduce one type of risk would probably work to increase another, and there is sufficient uncertainty that it is better to do nothing until the picture is clearer," Poloz wrote in an October 2014 discussion paper.

Scotia's Holt warns that the central bank would be stimulating unhealthy growth if it delivers a rate cut Wednesday.

“The effects of a rate cut are more likely to be reflected in interest rate sensitive sectors than the ones affected by the terms of trade shock,” he said. “[A cut] can do more to fuel financial imbalances than help the parts of the economy that are under stress.”

This potential conflict between a central bank's most basic task--to stabilize the business cycle--and the quest to return inflation to target within a normal time frame, make the bank's decision worth watching for market participants well beyond the nation's borders.

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