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The Bank of Canada (BoC) released its latest Monetary Policy Report (MPR) last Wednesday.
I always read this report with great interest because it gives us the BoC’s views on the state of the world’s largest economies and includes projections for where the Bank sees foreign and domestic economic momentum headed over the next several years.
I have criticized several of the BoC’s recent MPR’s as being wildly optimistic so I was interested to see this latest version offer a much more cautious view. To be clear, I understand that the Bank must always hedge its comments about our prospects with a little rose colouring, given the influence that its words can have on both our bond and equity markets. But whereas previous MPR reports seemed to require the willing suspension of disbelief, the optimistic tint in this latest version was left more to the margins.
Here are my two key takeaways from the report:
- The Bank finally dropped its tightening bias (which was more commonly known as its repeated warning that interest rates would rise more quickly than most Canadians were expecting).
This tightening bias should have been removed long ago. We have been mired in a low-growth world with no real threat of significantly higher inflation for longer than that bias has been in place. It was obvious to everyone that the Bank was using this warning as a form of moral suasion in an effort to rein in household credit expansion. There was wide agreement that actually tightening monetary policy to curb household borrowing rates at a time when the broader economy actually needed looser monetary policy would be like using a hacksaw for a job that called for a scalpel. This view was repeatedly validated when Federal Finance Minister Flaherty made four rounds of changes to our mortgage rules while the BoC stood pat.Meanwhile, because borrowers weren’t buying the BoC’s threat of higher rates the bias had no discernible impact on household borrowing activity. But it did serve to prop up the already expensive Loonie and may have caused some businesses to forgo capital investments they otherwise would have made. That’s why many argue that the bias was doing more harm than good, and as it rang increasingly hollow over time, it also diminished some of the BoC’s overall credibility. For those reasons it simply had to go. Good riddance.
- The Bank now believes that the recovery “will take longer than previously projected” and its views on inflation imply that the Bank’s overnight rate, on which our variable-mortgage rates are priced, will not be raised until late 2015 at the earliest.
To wit …
“The output gap in the base-case projection is anticipated to close around the end of 2015.”
The output gap is the difference between our actual economic output and our potential economic output. When the output gap is wide, there is little upward pressure on inflation. Conversely, when the output gap narrows, the risks of higher inflation and higher interest rates rise.
“Total CPI inflation is expected to return gradually to target around the end of 2015.”
This is consistent with the output gap comment above.
“ [U.S.] Monetary policy remains highly stimulative, with members of the Federal Open Market Committee expecting the first increase in the federal funds rate to occur only in 2015.”
As I have written in many posts (here are my most recent comments on the topic), the BoC can’t move its overnight rate until the U.S. Fed moves its policy rate first, and while the Bank will never openly admit this, the Fed’s timing will effectively dictate the BoC’s next tightening move.
In the MPR report the Bank listed both the main downside and the main upside risks to future growth. Here were the risks that were highlighted, with my comments under each:
- A more protracted and difficult euro-area recovery.
Given that the euro zone’s leaders haven’t fixed any of the region’s structural flaws, I continue to believe that it is still only a question of when, not if, the next euro-zone crisis will occur. Also, I’m not ready to hang my hat on the slight rebound in euro-zone growth that we have seen lately.
- Weaker exports.
This MPR was decidedly negative on the U.S. economy’s prospects and given that we still sell about 80% of what we export into U.S. markets, weaker export demand seems likely. Unless you think that the free-trade agreement we just signed with the EU is going to swing momentum in our favour. In that case, it will probably take a good couple of years before that agreement is finally signed and approved by each individual country member of the EU (and see my comments above on the euro-area recovery).
- A disorderly unwinding of household sector imbalances.
If our house prices resume their sharp upward rise I think Mr. Flaherty will announce more rule changes, such as raising the insurance premiums charged on high-ratio mortgages or insisting that all mortgages be qualified using a 25-year amortization. If this happens I will probably continue to support Mr. Flaherty’s efforts, but that doesn’t mean I won’t be worried that he is tempting fate. It takes time before the true impact of regulatory changes like these can be known and the more he tightens, the higher his risk of over tightening becomes. Of course, if Mr. Flaherty does nothing to slow rising house prices, then the market’s eventual unwinding of our house price-to-income imbalances could be far more “disorderly”.
- Stronger growth in advanced economies.
Is it just me or does it seem that the downside risk section of the MPR should have been easier to write? I know there are some very smart economic optimists out there and I read their viewpoints regularly. But so far they just haven’t convinced me. In a world where most of the largest economies are fuelling their growth (tepid as it may be) with a combination of massive stimulus and ultra-loose monetary policy, I still think that today’s global recovery is being built on sand.
- A quicker rebound in confidence and business spending.
I suppose it’s possible but there is so much uncertainty in the world that I don’t see confidence levels significantly rising any time soon. Here are some examples of what I think will continue to hold business confidence and spending in check: the U.S. fiscal and debt-ceiling fight, which is merely pausing until January for an intermission; the if and when of the Fed’s taper, which hangs over markets like the sword of Damocles; the next round of euro-zone bailouts, which is imminent and could come with protests, and possibly riots, in donor and donee countries alike; Japan’s determined march toward 2% inflation, which will essentially bankrupt its government when achieved. I could go on.
While I will give the BoC credit for the more cautious (and realistic) view it offered in the latest MPR, its rose-coloured crystal ball is still plain to see. The Bank continued to use its well-established habit of downgrading its short- and medium- term growth forecasts and, as an offset, compensating for this by upgrading its longer-term view. This is an attempt to solve the problem of trying to maintain a neutral view in tough times. As these forecasts draw nearer it becomes more difficult to ignore reality, so the BoC’s regular forecast downgrades are unavoidable. The MPR’s more optimistic longer-term forecast is then crafted as reassurance to would-be optimists that brighter times are still ahead. Never mind that these halcyon days have lately remained fixed on the far horizon. The Bank is bound to be right eventually, and in the meantime, they can keep leaning on their ubiquitous “margin of error” qualifier to tidy up any overly optimistic forecasts as they move closer to the present day.
Five-year bond yields were twelve basis points lower last week, closing at 1.71% on Friday. Bond markets liked that the BoC finally removed its tightening bias and bond yields dropped on the news. Lenders continue to inch their five-year fixed rates back down, but so far, mostly with promotions that offer shorter-term rate holds for deals that are closing fairly quickly.
Five-year variable rates are being offered in the prime minus 0.50% range, which works out to 2.50% using today’s prime rate of 3.00%. The BoC’s latest MPR makes it increasingly likely that the Bank will not raise its overnight rate for at least the next two years. In that event, the odds that the variable rate will save you money over today’s five-year fixed rates should be stacked in your favour. (Here is a recent rate simulation that I ran based on this key assumption. It’s a little out of date but the gap between today’s fixed and variable rates has widened since I wrote it, which tilts the playing field even more in favour of the five-year variable.)
The Bottom Line: The BoC’s decision to drop its tightening bias and offer a more cautious outlook in its latest MPR opens up the possibility that its next overnight rate move may actually be down, not up. While the variable rate is now sure to grow in popularity, more than one of us have been arguing in its favour for some time.