Canadian Monetary Policy Report: The Rest of the Story

October 22, 2009

As always, the Bank of Canada quarterly review is extensive, and wire service headlines do not do justice to the nuggets and other insights that one finds inside the report.

The statement released two days ago when an unchanged 0.25% overnight target rate was retained created a commotion in the market with the claim that current C-dollar appreciation “is expected over time to more than fully offset the favorable [economic] developments since July.”  In today’s report, projected world growth in 2010 has been revised up to 3.1% from a forecast of 2.3% in July, but projected Canadian growth next year remains at 3.0%.  In a separate breakdown of anticipated global growth, the biggest projected improvement, 1.4 percentage points to 3.3%, is recorded in “rest of the world,” that is everything but China, Japan, the euro area and the United States.  Among the five regional categories, only projected Japanese growth was revised down.  The weakest expected growth next year among the groups will be experienced in the euro area.

Canadian growth in 2008 and what Bank of Canada officials project for this year, respectively +0.4% and minus 2.4%, are below the forecasts for the global economy of +2.9% and minus 1.6%.  The 5.4 percentage point (ppt) improvement of growth from -2.4% in 2009 to plus 3.0% in 2010 occurs despite a 1.2 ppt drop in net exports.  The positive offsetting swings from the contributions of other components of demand will be 2.0 ppts from business final investment, 1.7 ppts from personal consumption, 1.8% from inventories, and 0.8 ppts from housing.  Support from fiscal spending only goes up by 0.3 ppts from 1.0 ppts in 2009 to 1.3 ppts next year.

A special technical digression is devoted to the natural gas sector, whose exports had been representing an increasing contribution to Canadian GDP until 2005 but a shrinking one more recently in line with diminishing natural gas prices.  In 2005, natural gas exports amounted to 2.6% of GDP, more than four times greater than crude oil exports, but those ratios by 2008 had converged to 2.1% and 1.7%.  This development is an additional reason for the drag of overall net export demand on Canada’s economy aside from an increasingly uncompetitive currency.  Deteriorating net exports next year will reduce Canadian GDP growth by a full percentage point from what such would be if net exports instead had a neutral effect on the economy.

Considerable new information is included in today’s report about productive capacity and estimates of how fast real GDP would climb if that capacity (labor as well as capital) were utilized fully. The difference at any point in time between actual GDP and potential GDP is called the output gap and plays a central role in official modeling of the future trajectory of inflation.  Whenever potential GDP exceeds actual GDP, demand-side inflationary forces are likely to be declining, and vice versa.  Monetary policymakers gets an A+ if they manage to lift GDP to the potential level and thereafter have such trend up exactly in line with potential GDP.  That sustains full employment without any buildup of inflationary pressure over time.

Potential GDP growth, like real GDP growth, waxes and wanes, and it is very difficult to measure exactly.  The Bank of Canada estimates that potential GDP expanded at rates of 1.7% in 2008 and 1.2% this year, whereas actual GDP went up 0.4% last year and is likely to record a drop of 2.4% in 2009.  The difference between those two vectors, 1.3 percentage points in 2008 followed by 3.6 ppts in 2009, defines the change in the output gap.  Such rose very sharply because potential GDP stayed positive, while the economy experienced a very severe recession.  The report estimates that the formally measured output gap had widened to 4.1% by last quarter.  However, that’s just one of several ways of calculating slack in the economy.  Others include measures of capacity usage, survey feedback on the difficulty that firms encounter in meeting unanticipated rises in sales, the ratio of unfilled orders to sales, the jobless rate, on-year employment growth, survey feedback on skilled labor shortages, and growth in both hourly earnings and unit labor costs.  Taking all this other information into consideration, officials at the central bank modified the 4.1% initially assumed output gap in 3Q09 inward to around 3.5%, which is still huge.

The next step is to create a future path for the output gap by comparing the estimated trajectories of real GDP and potential GDP in 2010 and 2011.  The differences in both years implies similar reductions of the output gap of roughly 1.5 ppts in each of those periods.  That pace of drop seems somewhat ambitious,  and I suspect the normalizing process will proceed a bit more slowly.  In any case, it probably will take two years or more from this past summer for the output gap to melt away.  By late 2011 or early 2012, one would want a monetary stance in place that limits growth to a speed limit defined by the rate of potential GDP in those out-years.

Before synthesizing all of this information into a projected inflation path, four other variables must be assessed thoroughly. 

  1. A monetary analysis of money and credit growth is done to see if their trends are consistent with medium-term price stability around the target pace of 2.0%.
  2. Various gauges of expected inflation are evaluated to ensure that such remains anchored tightly with the central bank’s mandated target.  The biggest development this decade in monetary policy theory is the elevation of expected inflation to the center of the process by most central banking authorities.  It is much easier to hit one’s goals if consumers, producers, and investors believe the central bank will succeed.  Credibility totally broke down in the 1970’s, and it took a long time for central bank goodwill to be squandered.  Officials weren’t watching expected inflation then, but they are now.  In this effort, officials know that it actually takes an accumulation of perceived monetary policy transgressions to break the line that tethers expected inflation to targeted inflation.  Inflation was a worldwide problem when I broke into this business.  After 35 years, I believe that it is much harder to develop am inflationary psychology than was realized in the 1970’s, 1980s, or 1990s. 
  3. Commodity prices are intrinsically volatile, and their wide swings, as well as the impact of indirect taxation, cause deviations between total inflation and core inflation.  Total inflation is what matters, but the Bank of Canada is one of many central banks that uses a measure of core to direct its decision-making.
  4. Forecasting risks must be evaluated.  The Canadian report concludes that “the overall risks to its inflation projection are tilted slightly to the downside,” suggesting a modest bias until we hear otherwise for officials to err on the side of a looser rather than more restrictive policy.

In the new forecast of the Bank of Canada, the recession ended in 2Q09.  Real GDP is projected to increase 2.0% at an annualized pace in 3Q.  Although no subsequent quarters are shown in the red, on-year growth doesn’t return to the the black until 1Q10 and remains between 3.0% and 3.6% from 2Q10 through the end of 2011.  Core inflation bottoms at 1.4% in the present quarter and next one and does not return to the medium-term target of 2.0% until 3Q11, a quarter later than in the forecast issued three months ago.  The 12-month pace of headline inflation has a huge 1.9 ppt swing from minus 0.9% in 3Q09 to +1.0% in 4Q09.  It steadies thereafter only because the central bankers impose the simplifying but dubious assumption of stable commodity prices.

The Bank of Canada hands out all of these gui
deposts in the name of policy transparency but does so with a big warning label that the assumptions upon which everything rests face huge uncertainties.  This is especially true of the estimation process of potential GDP.  A virtual disclaimer is now included with every document that reads, “the Bank retains considerable flexibility, consistent with the framework” … of the mandate for stable prices.  One point is that forecasting and policymaking are dynamic processes that must be constantly broken down and rebuilt to incorporate new information.  A second point is that transparent policy doesn’t mean telling the public precisely what will be done.  Central bankers are no more clairvoyant than the rest of us.  Rather, transparency means giving analysts the tools and raw information to understand how monetary policy is run to convey a sense that decisions are made within a framework, not on a whim.  Market players are encouraged to plug in their own best assumptions about the future to understand what policymakers are likely to do if their assumptions prove indeed correct, as what they might do under alternative assumptions.

In the Bank of Canada’s case, what can be said?  Foremost, the promise not to raise rates before mid-2010 seems consistent within the building blocs that today’s report provides.  Secondly, the central bank will need to begin raising rates not long after mid-2010 if its assumptions between 3Q09 and mid-2010 are more or less accurate.  From 0.25% at the start, the overnight target rate will need to rise quite a bit between mid-2010 and early 2012 by which time policy may need to have returned at least to a neutral setting.  Thirdly, Canada faces both uniquely good news and bad news.  The bad news is the Canadian dollar’s excessive rise, which will create heavy headwinds.  The good news was buried in a comment with little elaboration that Canada’s financial conditions are not only improving as is the case in many countries but that they are more favorable than those found in most other advanced economies.

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

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