Want A Cheaper Loonie? No Need to Cut Rates If Jawboning Does the Trick

The Bank of Canada (BoC) left its policy rate unchanged last week, as was expected, but it surprised markets by offering a decidedly dovish outlook in its latest Monetary Policy Report (MPR).

The most recent MPR was best summed up by BoC Governor Poloz during his press conference, when he said that the report forecasted “a lower profile for economic growth, an extended period of economic slack, and a later return of inflation to the 2% target.” His statement, at the accompanying press conference, provided us with another example of the Bank’s favourite monetary-policy tool of late: jawboning.

Jawboning is a term that describes using words instead of actions to produce desired outcomes. When central bankers jawbone, they use their bully pulpit to move markets in a certain direction. In last week’s case, the BoC used its dovish language to help keep the Loonie from appreciating, and to buy some time until the U.S. Federal Reserve hikes its policy rate and the Greenback rises in response (which will weaken the Loonie and provide further stimulus to our exporters).

As far as monetary-policy tools go, jawboning, if effective, is a preferred option. It replaces quantitative easing and other more permanent forms of central-bank balance-sheet expansion, and while cutting rates is a more sure-fire way to devalue your currency, when your overnight rate sits at 0.50% (as ours does now) you don’t have much dry powder left and you don’t want to make more cuts until you have no other choice.

Also, if you do end up having to cut your policy rate later, the Loonie is likely to sell off again, taking it down another notch, so your jawboning plus an eventual rate cut should give you two currency devaluations for the price of one actual move.

Here are the highlights from the latest MPR, with my comments added:

International Economic Outlook

• The Bank observed that there has been a recent reduction in global trade, noting that the G20 countries have enacted a total of 1,583 new trade restrictions since 2009, with 145 of these new measures being applied during the six months from October 2015 to April 2016. This is a concerning trend for a small, open economy like ours whose economic momentum tends to mirror overall global growth, and it helps explain why our export businesses have been reluctant to invest in productivity enhancements and capacity expansion.
• “The U.S. economy is expected to strengthen in the second half of 2016.” This view is based on several beliefs that inventory investment will turn positive, after “being a drag on growth” for the past five quarters”; that “business investment should regain momentum” thanks to “a rising oil rig count”; and that residential investment will “resume growing” after contracting in the second quarter. Lots to hope for there. Meanwhile, consumption growth is expected to remain strong, “underpinned by robust consumer confidence and a strong labour market, with ongoing robust job gains over the past several years.” Are we talking about the same U.S. employment market that I have been watching over those same years? The same one that has lots of unused potential, barely rising incomes, a surfeit of low-paying part-time jobs and legions of disgruntled under-employed workers who are lining up to vote for a presidential candidate who wants to rip up every trade deal and start over? Robust is not a word I would use to describe the current U.S. labour market. But I digress.
• “The Bank of Japan (BoJ) has introduced two new major components into its monetary policy framework: ‘yield curve control,’ in which the BoJ will seek to control both short- and long-term interest rates; and an ‘inflation overshooting commitment,’ in which the BoJ commits to expand the monetary base until consumer price inflation exceeds the 2 per cent target and remains stable above the target.” Have any of you parents out there ever taken your children go-karting when they were too young to drive alone, and been given a special car with two steering wheels – but the child’s steering wheel doesn’t actually steer the car, it just makes them think it does? That reminds me of the BoJ trying to use its monetary policy to influence the Japanese economy. At this point, they’re pretty much out of monetary-policy bullets, at least effective ones. The BoJ might think it is driving a go-kart, but in reality, at this point they are on a roller coaster riding the rails and picking up speed, with a brick wall about a mile or two down the track. The BoJ can swing its steering wheel back and forth all it wants – at this point I can’t see it changing the ultimate outcome.
• The Bank is forecasting that growth in China will slow to 6.3 percent by 2018. “Previously announced fiscal support and rapid credit expansion appear to be boosting growth in spending on infrastructure and in the housing sector. While these developments are helping to replace some lost demand from slowing investment in mining and manufacturing industries, they may exacerbate financial vulnerabilities by increasing leverage, particularly in unprofitable state-owned enterprises.” May exacerbate vulnerabilities? China has been trying to transition its economy from one based on export manufacturing to one that is focused on a rising domestic service sector. Since the start of that attempted transition, every time China has reduced the free flow of debt, its economy has been hammered, to the point where it seems fairly obvious that China is entirely dependent on debt-financed growth. If history is any indication, this will not end well.

Canadian Economic Outlook

• The Canadian economy shrank by 1.6% in the second quarter, largely as a result of “a large, broad-based decline in goods exports and the impact of the Alberta wildfires.” The Bank is hopeful that the economy will rebound in the second half of this year after we see “a return of oil sands production and rebuilding activity in Alberta” – and if the pickup in exports that we saw in July and August continues.
• The Canadian economy “is progressing against a backdrop of weak but improving global demand”, but “persistent competitiveness challenges are restraining the pace of export growth.” The Bank offered several interesting observations relating to that last sentence:
  1. It estimated that weakness in the demand for our exports, both in the U.S. and globally, accounted for only “about half of the shortfall in exports relative to what we were expecting.”
  2. For the other half, the Bank looked “at a range of structural factors, including lost export capacity and competitiveness challenges.” It attributed the loss in export capacity to “deficient infrastructure, regulatory uncertainty, rising trade barriers, relatively high electricity costs and the unknown status of current and future trade agreements.” These challenges were deemed to be fairly permanent in nature, and to account for them the BoC reduced its projected level of GDP to “about 0.6 per cent by the end of 2018.”
  3. From a competitiveness standpoint, the Loonie’s weakening against the Greenback was expected to boost our exports to the U.S. more than it has. The BoC explained part of the shortfall by noting that competing countries have seen even more depreciation against the Greenback. For example, “the Mexican peso has fallen by more than 30 per cent against the US dollar since mid-2014, while the Canadian dollar has slid by less than 20 per cent over the same period.” Perhaps a little jawboning is in order to help close that gap?
• The Bank is estimating that a combination of the federal government’s recently announced infrastructure spending plans and the rollout of the Canada Child Benefit will “boost the level of Canadian GDP by about 1 per cent over the 2017–18 fiscal year.” It expects this boost to be partially offset by “the government’s measures to promote stability in the housing market”, otherwise known as the most recent mortgage-rule changes, which it estimates will “reduce the level of GDP by about 0.3 per cent by the end of 2018, although there is much uncertainty around that estimate.” I agree about the uncertainty part, because real estate has accounted for an outsized share of our GDP growth over the past several years. If you promised me just a 0.3% drop in GDP as a result of the recently announced changes, I would take it and run.
• On the inflation front, while the Bank now believes that inflation “should be close to the 2 per cent target in 2017 and 2018”, it is now projecting that the output gap will not close “until mid-2018”. The output gap is a key measure for anyone keeping an eye on mortgage rates because the BoC would be expected to start raising its policy rate when the output gap closes – although keep in mind that, for years now, the Bank has consistently overshot with its predictions on when this will actually happen.
• The Bank noted that “nearly 250,000 jobs have been created in the service sector since the end of 2014, while jobs in the goods sector declined by about 70,000.” It observed that “while the average wage in service industries remains lower than that in goods industries, most of the increase in employment since the latter part of 2014 has been in service industries that pay above-average wages.” To which I would ask, how many of those higher-paying service jobs were real-estate related jobs, and what’s your forecast for those incomes dropping after the latest round of mortgage rule changes? (To be clear, that isn’t a criticism of the mortgage rule changes, but rather of the Bank’s estimates of their impact on average service-sector incomes.)

Five-year Government of Canada bond yields fell thirteen basis points last week, closing at 0.65% on Friday. Five-year fixed-rate mortgages are available in the 2.29% to 2.39% range (for now), and five-year fixed-rate pre-approvals are offered at about 2.59%.

Five-year variable-rate mortgages are available in the prime minus 0.40% to prime minus 0.50% range, which translates into rates of 2.20% to 2.30% using today’s prime rate of 2.70%.

The Bottom Line: If Canadian economic growth is going to pick up, our exports have to lead the way. And since the Canadian dollar has only fallen by 20% against the Greenback while the Mexican peso has dropped by 30%, a little jawboning by the BoC might help close that gap and give our exporters a much-needed boost. If it doesn’t, then expect the Bank to drop its overnight rate at its next meeting, which it is more able to do now that the Department of Finance has taken some of the wind out of the housing market’s sails (and sales!)

Mind you, if the BoC does cut rates again, there is no guarantee that variable mortgage rates will follow because lenders may not pass on any of that additional discount. But it should mean, at least, that both our variable- and fixed-rate mortgages will stay at or near their current levels for the foreseeable future.