Semi-Annual Canadian Monetary Policy Report

April 23, 2009

The Bank of Canada today

  • Reiterated that its overnight rate target of 0.25% will not be cut further, but neither will such be raised before mid-2010 assuming inflation behaves as officials assume,
  • Presented and explained new global and Canadian forecasts for growth and inflation,
  • Expressed the belief that monetary and fiscal stimulus are now ample enough to achieve economic recovery and a return of total and core CPI inflation to the 2.0% target by the second half of 2011, and
  • Refrained from taking unconventional quantitative and/or credit easing steps now but outlined a set of principles to guide such actions should the current monetary policy in the future be deemed inadequate to deliver a return to the mandated parameters of medium-term price stability.

The quarterly path of Canadian growth was revised to show a deeper and longer recession caused by the collapse of global trade, more insidious feedback loops between real economic activity and breakdowns in the financial system, and delayed policy repairs of the financial system.  Negative growth in 2009 is now projected at -6.2% in Japan, -3.6% in the European Union and -2.4% in the United States.  Global growth has been revised downward by 1.9 percentage points to -0.8% this year and by 1.5 percentage points to 2.2% in 2010 before improving to 3.7% in 2011.  Canada’s output gap, a gauge of unused labor and capital associated with disinflation, but not deflation, is measured to have been 3.0% wide by last quarter.  However, incremental growth in the output gap, which crests in 4Q09, is constrained by a much slower expansion of Canada’s potential GDP.  Officials estimate that this speed limit will be only 1.2% this year, 1.5% in 2010, and 1.9% in 2011, all well below estimates embodied in their last set of projections.  The new projected path of Canadian growth at a seasonally adjusted annualized rate (saar) and targeted core CPI from a year earlier (y/y) is shown below.

  GDP SAAR Core CPI Y/Y
1Q09 -7.3% +1.9%
2Q09 -3.5% +1.6%
3Q09 -1.0% +1.3%
4Q09 +2.4% +0.9%
1H10 +3.5% +1.1%
2H10 +4.6% +1.4%
1H11 +5.0% +1.8%
2H11 +4.5% +2.0%

The really anticipated portion of the central bank report is contained in a three-page annex, which lays out a contingency framework should a need for easier monetary policy emerge. Three tools are identified, but only the first has been already put into effect.  That step involves the inclusion in each scheduled policy announcement of a conditional future path for the overnight rate target.  The hope here is that anchoring the short-end of the yield curve will clarify expected inflation going out about a year and thereby depress the whole structure of rates.

The second tool would be quantitative easing, that is the purchase of financial assets such as T-bills and short-term government bonds by the creation of high powered money, and the third possible tool would entail the buying of private-sector assets to cut excessive risk premiums in certain financial sectors and to promote better market liquidity.  This third tool could boost central bank reserves or not depending on how the Bank of Canada chooses to finance the operation.

A number of broad principles will govern the choice and mix of tools two and three:  ensuring that the medium-term inflation target doesn’t get compromised, optimizing the expected real economic boost of the monetary easing, avoiding market sector distortions, minimizing danger to the central bank’s own balance sheet, preparing for an effective and timely exit strategy from unconventional monetary policy and precisely communicating to markets and the broader public what new steps are being taken and the reasons for taking such actions and the intended results.

The Annex applies to Canada but addresses what all central banks will need to consider when engaging in the unchartered waters of quantitative easing, so I strongly recommend reading this portion of the Policy Report.  As for the rest of text, my chief criticism is the assumption of very rapid economic growth after the recession.  The Bank of Canada is hardly alone in that view.  President Obama’s budget proposals also contain very optimistic assumptions about out-year growth.  What this optimistic view seems to be doing is adopting the 1934-7 Great Depression experience as a blue-print.  I think Japan’s performance since 1991 provides a much more analogous blueprint.  The kind of deflation experienced by the United States in 1929-33 isn’t happening now.  Japanese growth since 1991 has only averaged about 1.0% per annum.

Copyright 2009 Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.

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