Once a quarter, the Bank of Canada simultaneously updates its policy, releases a new quarterly economic outlook and sends the governor and the senior deputy governor out to meet the press. It’s a lot to take in all at once.
The headline on April 12 was that the Bank of Canada left the benchmark interest rate unchanged at 4.5 per cent, but is considered raising borrowing costs because policy makers are inflated is on a trajectory that will see it fall back to the two per cent target. But there were other things worth noting. Here are three observations that shed light on the central bank’s thinking:
The market isn’t always right
There’s a disconnect between the Bank of Canada and those who earn their livelihoods betting on the trajectory of interest rates.
Perhaps the most notable moment in governor Tiff Macklem’s press conference on April 12 was when he went out of his way to send a message to the traders who think he’s going to cut interest rates this year: you’re almost certainly wrong.
Macklem’s opening statement emphasized that he and his deputies debated whether they had raised interest rates high enough to arrest inflation. Notably, there was no mention of any discussion about lower interest rates. That’s because the Bank of Canada’s new forecast shows it will take at least another year — and probably longer — to get inflation back to the two per cent target. Cuts aren’t on the table.
“Based on the information we have today, the implied expectations in the market that we are going to be cutting our policy rate later in the year, that doesn’t look like the most likely scenario to us today,” Macklem said.
The governor probably isn’t concerned about saving a group of relatively wealthy investors from a bad bet. For his policy to have its full effect, he needs financial conditions to tighten — and stay tight. The opposite has happened over the past month. The average yield on one-to-three-year government debt is now around 3.75 per cent. That’s significantly higher than a year ago (when it was about 2.3 per cent), but down from 4.2 per cent in early March, before the Silicon Valley Bank crisis.
It’s unclear why bond investors are so unwilling to play along. One possibility is that they are sending the Bank of Canada a message of their own: we’re not the ones who are wrong.
“There is no economic construct either on practical or theoretical grounds that will fail to cause inflation to decelerate — what the bank is focused on is the speed of the deceleration, but we are convinced that the destination will come sooner, not later,” David Rosenberg, the widely followed Bay Street economist, advised his clients after the Bank of Canada’s latest policy decision. That means more demand for government bonds — which puts downward pressure on yields because of their inverse relationship with bond prices — and a weaker dollar, Rosenberg said.
Investors might also be telling the Bank of Canada that they have come to doubt that central bankers have the courage to back up their tough talk on inflation. The past couple of decades have featured former Federal Reserve chair Alan Greenspan’s experiments with loose monetary policy and a progression of extraordinary rescues each time the economy went off the rails. Macklem himself pledged in 2020 to leave borrowing costs pinned near zero for two years, and followed through even though it had become clear that inflation was taking off.
Macklem emphasized that if he made any policy changes this year, the rate would increase. If he wants to change market expectations, he might have to follow through.
Governments aren’t helping
Ideally, monetary policy and fiscal policy complement each other. But it rarely works that way. After the Great Recession, former prime minister Stephen Harper was in a hurry to balance the budget. The economy was still weak, so the Bank of Canada was forced to keep interest rates lower for longer to offset deflationary forces. Easy money stocked the housing bubble.
Now, Prime Minister Justin Trudeau and many of the premiers are throwing money around, despite the most dangerous burst of inflation in four decades. That’s making the Bank of Canada’s job that much harder. Interest rates will probably be higher for longer, risking an extended period of slow economic growth. The central bank’s latest forecast predicts no growth in business investment over the next couple of years at a time when companies should be adapting to the green transition and the digital economy. The Bank of Canada reckons many won’t be because the cost of capital is too high.
The budget season ended with so many spending promises that the central bank felt compelled to devote a section of its latest Monetary Policy Report to fiscal policy. Policymakers described spending growth in the second half of 2022 as “robust,” and predicted that spending “will contribute steadily” to GDP growth over the next couple of years. In all, the central bank said it added $25 billion per year in government spending through 2024 since its January outlook, citing as examples the federal government’s $2.5-billion pledge to extend the temporary GST tax credit for low-income households, and Quebec’s plan to implement $1.7 billion in income tax cuts annually starting in 2023.
Macklem told reporters that all these fiscal measures neither help nor hurt his efforts to lower inflation. “Government spending plans are not contributing to the slowing of growth in our projections but at the same time they are not standing in the way of getting inflation back to target,” he said.
So, it could be worse. But it’s fair to ask whether the fiscal authorities could be helping the Bank of Canada get inflation back to target, rather than just staying out of the way. “It’s a stretch to believe that government spending plans motivated the (Bank of Canada) to upgrade growth but this has no effect on inflation risk,” Derek Holt, an economist at Bank of Nova Scotia, said in a note to his clients. “My take is that the (Bank of Canada) does believe fiscal policy is making their jobs more complicated but they are letting the numbers do the talking.”
Canada’s banks passed another test
The most read story at the Financial Post last month was an explainer on Canadian deposit insurance. The collapse of Silicon Valley Bank and Signature Bank in the span of a few days prompted the Fed and the Treasury Department to promise to protect all depositors. Swiss authorities forced troubled Credit Suisse Group AG to sell itself to UBS Group AG. It felt like 2008, when a global financial crisis triggered the Great Recession.
But that was March. Unlike 2008, central bankers and regulators quickly consumed the flames before they turned into an inferno and the world now appears to have changed on. The banking turmoil received surprisingly little mention in the Bank of Canada’s new quarterly outlook. The report predicts Canada will feel the effects indirectly through exports, as the after effects of the crisis have resulted in tighter financial conditions, which will curb US demand. Aside from that, Canada’s central bank appears to see no lasting effects.
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“Fortunately, both the US and the Swiss authorities intervened quickly and contained that immediate contagion effect,” Carolyn Rogers, the senior deputy governor and a former banking regulator, said at the press conference.
Rogers observed that banks’ funding costs have increased and that there is “still a little bit of pressure” on bank stocks. “What usually results is a bit of a pullback in lending,” she said. “So, the effects begin to move more into growth. In our forecast, we expect to see that primarily in the US and to a lesser degree in Europe, and that will feed through overall to growth,” Rogers continued. “But for now at least, the immediate stress has been contained and that’s a good thing.”