Bank of Canada Monetary Policy Stance Eased for Second Time This Year

July 15, 2015

A famous Monty Python skit produced the line, “Nobody expects the Spanish inquisition,” and the idea applies equally well to the forecasts of public authorities particularly central banks when it comes to forewarnings about coming recessions. 

In cutting the overnight money target by 25 basis points to 0.50% today, Bank of Canada officials published an updated quarterly Monetary Policy Report that lo and behold shows a recession (that is successive quarters of GDP contraction) in the first half of 2015.  But not to worry because the downturn was brief, and positive growth will resume in the current quarter.  The rate-cutting press release announcing today’s interest rate reduction speaks of a “significant and complex adjustment” in Canada’s economy this year caused by the temporary lull in U.S. demand, a more enduring slowdown in China, resulting drops in the prices of certain Canadian exports (energy as well as non-energy items) and softness among some non-commodity exports, too. 

Several inferences are drawn.  Officials expect Canadian GDP to expand just 1.1% this year, down from an estimate of 1.9% made just three months ago.  Canada’s output gap — the measure of slack in the economy — is significantly larger now than was expected at the time of the April review, and instead of being eliminated late in 2016, such is now not projected to disappear until some time in the first half of 2017.  Total and core inflation will decline and stay below the 2.0% target until the second quarter of 2017 even taking into account today’s rate cut and a similar reduction from 1.0% to 0.75% made in January.

Canadian officials present today’s action as a required response to “help return the economy to full capacity and inflation sustainably to target.”  The deviation, as in the Bank of Japan’s explanation for not reaching its inflation target, is framed as a result of external shocks occurring elsewhere in the world by affecting commodity-sensitive Canada.  What hasn’t been said is that in 2010, the Bank of Canada differentiated its policy from the Fed’s with three 25-basis point rate hikes in June, July and September, lifting such from 0.25% to 1.0%, while the federal funds rate all the while remained pinned in a range of zero to 0.25%.  The Canadian-minus-U.S. central bank interest rate spread has now been trimmed back and will in fact become negative as Canada declines initially to follow the Fed’s rate normalization lead in the months ahead.

But damage already has been done.  By creating an interest rate premium almost five years ago, the Bank of Canada laid the groundwork for Canadian dollar appreciation that made the economy especially vulnerable to external shocks.  It chose to increase the economy’s susceptibility to old dangers, namely too high inflation, rather than the new skewness of risk which has been in the direction of less growth and inflation than generally assumed.  Put differently, Canadian authorities placed greater weight on avoiding the side-effects of excessively prolonged zero interest rates such as “elevated vulnerabilities associated with household imbalances.”  Canada in 2015 has paid a price for that choice, and at this juncture, the Fed seems to have played the recovery better than its Canadian counterpart.  A final verdict can’t be made, however.  Only time will tell if the Fed can navigate an escape from its emergency policy settings without the U.S. economy paying a price for keeping its policy ultra-loose as long as it did.

Copyright 2015, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.



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