Has the Bank of Canada Discovered Life on Mars?

The Bank of Canada (BoC) left its overnight rate unchanged last week, as expected.

The Bank also released its latest Monetary Policy Report (MPR), which I read with great interest because it gives us the BoC’s views on the state of the world’s economies and includes projections for where the Bank sees foreign and domestic economic momentum headed over the next several years.

In a perfect world, the MPR would offer an unbiased assessment but bluntly put, that has not been the case for some time now. The BoC remains primarily concerned about our elevated household debt levels and continues to warn Canadian consumers about higher future interest rates. The Bank’s hope is that this form of ‘moral suasion’ will help counteract the natural effect that its ultra-low interest-rate policy is having on household borrowing. If successful, the BoC would be able to continue stimulating the rest of our small, open economy, which is needed in light of current global economic conditions, without fueling a household credit bubble as a by-product.

The challenge that the BoC has today when drafting its MPRs is that it must support its higher interest-rate warning with forecasts to match. This is where the tangled web that tries to connect the Bank’s warning to the hard economic data can be most plainly seen.

A pattern has emerged in the last several MPRs where the Bank downgrades its current data and near-term forecasts, unable to deny that our near-term economic momentum is slowing, but then offers more optimistic medium-term projections as an offset. This is a clever way of massaging the data because it allows the Bank to use a distant pickup in economic momentum as a way of continuing to justify its threat of higher interest rates, even while we are clearly still in the midst of an economic slump. Then, later, as the future unfolds and that momentum doesn’t materialize, the BoC simply adjusts its projections downward as they move nearer to the present day and makes new medium-term projections to fit as needed. Wash, rinse, repeat (and hope no one notices).

Let’s look at what the latest MPR is forecasting for export growth in various economies around the world as an example:

• US – “Firming foreign demand is projected to support a steady rise in U.S. exports through 2015 ….”
• Euro area – “Economic activity in the euro area is expected to decline further during the first half of 2013, although at a slower pace. A gradual recovery, initially supported by external demand, should then take hold”.
• Japan – “The recent sharp depreciation of the yen, coupled with an increase in external demand, is also expected to spur a significant rebound in exports.”
• China: “A rebound in exports is also anticipated ….”

The BoC’s rosier medium-term view seems to be largely underpinned by the view that world’s economies will soon enjoy across-the-board increases in export demand, despite the fact that the world is in the midst of a massive and growing currency war and despite a rise in other protectionist policies that typically occur in times of economic slowdown. The BoC’s key assumption on exports flies in the face of all evidence to the contrary and begs the question – where will all of this increased demand for exports come from? Have our central bankers discovered a secret source of hidden demand that only they (and probably Goldman Sachs) are aware of? Has our search for life on Mars discovered a new species of well-healed consumers who can’t wait to live beyond their means?

** Spoiler alert ** Here is a sneak preview of the BoC’s MPR in 2014 (my construction): “The rise in export demand that was forecast in previous MPRs has not materialized due to the slower-than-expected pace of economic recovery in many of the world’s largest economies. This reduced economic momentum has also coincided with a rise in protectionist, beggar-thy-neighbour policies that have led to lower export demand than originally projected.”

Here are some other examples of assumptions that seemed like ‘reaches’ in the latest MPR:

• The BoC believes that both the U.S. and Canadian economies will benefit from an improving U.S. housing market, largely because increased residential investment has historically created spillover demand in other housing-related sectors. I question whether this well-established precedent is applicable today, however, because first-time buyers are not driving the U.S. housing recovery. The marginal buyers of U.S. houses today are investors, who are far less likely to buy related goods, like furniture and electronics, for their newly purchased rental properties.
• The Bank is projecting a rise in both U.S. and Canadian business investment but it also acknowledges that it has not materialized to date. Instead of investing in longer-term projects, businesses have focused on small capital outlays with more immediate, but smaller, returns. Today, the most well-known business-sentiment indices such as the U.S. Fed’s Beige Book and the BoC’s Business Outlook Survey show falling, not rising, business confidence and project only modest business-spending increases. As such, assumptions about medium-term increases in business-investment appetite that return our economy to full capacity by mid-2015 seem more like wishful thinking than anything that is based on facts on the ground.
• The BoC sees the main upside risks to be “stronger-than-expected-growth in the U.S. and global economies, a sharper-than-expected rebound in Canadian exports, and renewed momentum in Canadian residential investment”. Conversely, the Bank sees the main downside risks to be: “the European crisis, more protracted weakness in business investment and exports in Canada, and the possibility that growth in Canadian household spending could be weaker”. While the Bank sees these offsetting risks as “roughly balanced over the projected horizon”, the latter risks seem much more probable to me than the former, especially when you consider that both the BoC and our Federal Finance Minister have been openly cheering our recent housing- market slowdown.

Government of Canada (GOC) five-year bond yields were two basis points lower last weekend, closing at 1.18% on Friday. Five-year fixed-rate mortgages are widely available at sub-3% rates as lenders continue to engage in aggressive spring-market rate competition.

Five-year variable rates are offered in the prime minus .40% to .45% range (which works out to 2.60% to 2.55% using today’s prime rate).

The Bottom Line: The BoC has painted itself into a corner by consistently warning Canadians about higher interest rates while global economic conditions continue to deteriorate. Higher interest rates are always a possibility, but they still seem like a distant threat to me and I don’t think the BoC’s latest MPR medium-term projections make a compelling case otherwise … unless NASA announces a Martian press conference in the near future.