As the BOC action today shows

it is good to avoid spurious talk of ‘normalizing monetary policy’ when we are living in a paradigm of wage stagnation, precarious employment, household indebtedness, rising inequality, and job losses from off shoring and technological change.

Monetary policy is supposed to be the elixir to fix this?

My disagreement on Twitter from last January…

BOC.rates

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BOC: Easing bias before a rate cut

Nice table here from Pension Partners (via @MktOutperform )

The Race to Negative Yields (%)

And here is the Canada 10 year Government Bond (from Trading Economics)

Canada10 Year Bond (2009-2015 YTD)

On January 21, 2014 I argued that the Bank of Canada’s policy rate would continue to flat-line for the year despite market optimism to the contrary. I also disclosed that I had added long bond exposure to my personal portfolio with the view that 2014 would be a bounce back year for sovereign long bonds, specifically Canadian. Little has changed to deter the portfolio choice as the global landscape worsens.

At home, in an era of what I believe are low rates for a very long time, financial repression is killing the spending capacity of retirees. A not so small point is that the front end of Canada’s baby boom generation began retiring last year. That is a trickle; a flood of retirees will follow. Central banks are relying on reduced interest rates to spark credit creation (and in turn a greater stock of private debt) to spark consumption. The price of real estate remains at a high in nominal terms in major cities like Toronto and Vancouver and household debt to income ratios remain high as well. To keep the not so virtuous cycle of consumption going will require the central bank to more encourage credit creation and asset price inflation to spur the industry that is growing –real estate development– however with the federal government attempting to balance its budget the output gap that the BOC calculates as a guide (but necessarily a final decision making metric for policy) is likely to expand rather than contract. With slack only increasing and knock on effects from oil’s price decline yet to be felt in the numbers that drive markets, 2015 will be another year of easy monetary policy. Absent increases in real wages of working and middle class workers there will be no spike in effective demand within the Canadian economy that will be sustainable. If anything, the case is now being made by Ted Carmichael and others for a policy rate cut. I agree with this view. While a rate cut on January 21 is unlikely the language leaning toward an easing bias may occur in the coming months. Reading the tea leaves of monetary policy statements is more art than science. If the BOC’s dovish language is enough then it will stand pat as long as it can but as the data flow increases and core inflation falls we will see a rate cut this year.

The scheduled announcement dates for BOC policy rates in 2015 are:

Wednesday 21 January
Wednesday 4 March
Wednesday 15 April
Wednesday 27 May
Wednesday 15 July
Wednesday 9 September
Wednesday 21 October
Wednesday 2 December

George Magnus on Boom and Bust

Fast forward to 4:00

George Magnus, former chief economist at UBS, in conversation with RT’s Erin Ade on the emerging markets sell off, the concern with China, the demographic challenges facing advanced economies as well as Russia and China, and an assessment of Ben Bernanke’s tenure as FED chairman.

BOC’s benchmark policy rate to continue flatlining

The Bank of Canada is set to release its interest rate announcement and Monetary Policy Report tomorrow morning at 10 AM (ET). There is an expectation of no policy rate change and the possibility of an easing bias by market participants. The former appears a good bet given the flow of economic data recently, from employment falling by 46,000 in December to  inflation remaining below the BOC’s 2% target yet remaining just within the central bank’s (1% to 3%) operating band.

 The chart below illustrates three metrics, 2 observable the other an estimate, that BOC watchers pay close attention to: core inflation (in dark blue), the BOC target (i.e. policy) rate (in teal), and the output gap (in brown measured against the right Y-axis). It is the latter that should be reason enough to believe that the BOC policy rate will continue to flatline for the short term (2 years) as the slack in Canada’s economy continues to widen despite a low nominal central bank policy rate, credit extension by the banking sector, and federal and provincial governments that are running budget deficits.  

core.outputgap2

My personal view is that there is no reason for the BOC policy rate to move up before the 2015 Federal elections. The Conservative government of Stephen Harper will be running, according to its Executive Director Dimitri Soudas,  on a platform of supposedly ‘strong, stable leadership’ (below).dimitri.soudas
Moreover, there is the determined effort on the part of the current Conservative Federal government to ‘balance the books’ and return Canada to the promised land of budget surpluses. For a graphic on how federal governments from the time of Lester B. Pearson’s Liberals to Stephen Harper’s Conservatives have fared in this endeavour, see this graphic from the CBC.

The idea of conflating the budget of a federal government with that of a household is attractive but it doesn’t work for Canada; it can for other nations, such as those under the monetary straitjacket of European Monetary Union, but it doesn’t make sense in the Canadian context. Every nation has a particular political economy to deal with that is the legacy of history and goepolitical relations. Moreover, the nature of a nation’s currency –is it sovereign or is it shared or pegged to global reserve currency– is worth considering as is the composition of that nation’s debt ownership.

Currently, the Canadian context is one where the household sector has taken on an increasing amount of debt –both residential mortgage and consumer– that will be serviced for the coming decades and at the same time the federal government has gone into deficit spending mode since the 2008 financial crisis.

Debt to income ratio in Canada

Debt to income ratio in Canada

household.debt.percent.GDP 

The Bank of Canada understands this and has made the explicit assumption in previous Monetary Policy Reports that the business sector would drive growth in the economy through capital investment. That hasn’t happened.

Arguably, businesses require signals from the consumer in order to have the confidence to enact capex. Say’s Law need not apply for most companies: supply does not create its own demand. The decision in favour of capex is demand driven. Absent that effective demand, businesses can propel growth via a combination of increasing efficieny or financial engineering. The former prescription has meant offshoring, outsourcing, and hiring more workers as temporary and, increasingly, the autommation of work that requires fewer and more specialized workers (if any as the graphic below concerning the decoupling of productiviy and employment illustrates).

destroying_jobs__chart1x910_0

The latter prescription has meant, at best, bringing leverage onto a company’s balance sheet as a catalyst to translate modest top line sales growth into robust bottom line profitability and, at worst, aggressive revenue recognition to make a balance sheet and income statement look better than it really is.

Fundamentally, the deficits of one sector emerge as the surpluses of another. If we consider the debt burden of most Canadian households in terms of the stock of liabilities divided by the flow of income, we recognize that the moribund income growth entails curtailing future discretionary consumption. Canadians have brought forth a lot of future consumption by taking on mortgage and consumer debt. This requires debt servicing. Furthermore, the demographic factors facing Canadian society are a challenge that this country’s policy makers are inadequately prepared for. As the dependency ratio increases, the growth trajectory decreases: older Canadians, many of whom have saved inadequately for retirement, won’t consume as they did during their working years.

The Bank of Canada will continue to cling to the hope that the sagging loonie will spur greater demand for Canadian exports and thus make their heretofore forecasts appear more credible. This is more faith and hope then scietific reasoning as the flipside to this is that it will make capital expenditures more expensive as that is invoiced in USD. The Canadian dollar remains a petrocurrency:

CAD remains a petrocurrency

CAD remains a petrocurrency

Head winds to growth:

  • Household deleveraging
  • Government deficit reduction
  • Aging demographics

Tail winds to growth

  • A depreciating currency
  • Credit expansion
  • Easy monetary policy

Market rates will continue to ebb and flow on the steady trickle of economic and financial data. Mortgage rates, in turn, will go up and down as a result based on the risk appetitite of the major banks. What won’t change is the policy rate: the Bank of Canada will be circumspect in articulating an easing bias as it won’t want to further inflame a housing market that is becoming expensive for most Canadians yet, in the face of the head winds facing the economy it is unlikely how the slack out of the economy will disappear over the coming years.

(Full disclosure: the author’s views are his own and he added allocation to XLB iShares in anticipation that 2014 would be a bounceback year for Canadian Long Bonds)

Werner to BBC: UK QE = FAIL

In both Japan and the UK, QE isn’t working, he says, because it doesn’t focus on “the most important part of the money supply”, which is bank lending. “UK QE has singularly failed, as bank credit is still shrinking.”

When faced with the claim used by some British banks that the demand for credit is low, Prof Werner is dismissive. “I’m quite used to this argument, because banks in Japan used it for 20 years,” he says. “The banks, of course, have become very risk-averse, as they have many non-performing assets.”

Prof Werner is also critical of the UK’s concentrated banking structure – which he argues has made the economy more vulnerable. “British banking is dominated by a small number of big banks – with just five banks controlling 90% of deposits,” he says.

Richard Werner talking to the BBC in their news item UK QE has failed, says quantitative easing inventor.

What is completely lost in that BBC article is that Werner has always emphasised that the effect of credit creation depends on the use of money. Werner cites two cases:

Case 1. The newly created purchasing power is used for transactions that are part of GDP. In this case, nominal GDP will expand: credit creation for ‘real economy transactions’ C(R) –> nominal growth can result in two outcomes

  1. Inflation without growth | Credit creation is used for consumption: more money coincides with the same amount of goods and services = consumptive credit creation
  2. Growth without inflation | Credit creation is used for productive credit creation: more money coincides with more goods and services = productive credit creation

Case 2. Newly created purchasing power is used for transactions that are not part of GDP (financial and real estate transactions). In this case, GDP is not directly affected, but asset prices must rise (i.e. asset inflation): credit creation for financial transaction C(F) –> asset markets.

  1. Asset inflation | Credit is used for financial and real estate speculation. More money circulates in the financial markets = speculative credit creation.

For a recent deck of his go here

One of the best books that few people know about let alone have read is Werner’s New Paradigm in Macroeconomics Solving the Riddle of Japanese Macroeconomic Performance

That will be covered in the future on this site as it will become more relevant that rate normalization will not be around the corner in Canada, USA or elsewhere where the debt burden for households is large, debt servicing long and the banking sector is fundamentally an extender of credit for real estate speculation, development and home buying rather than a lender for funding new startup entrepreneurial ventures that are critical to economic rejuvenation but also risky: most fail. There isn’t an immediate solution to the lack of funding for start ups but new models of peer to peer lending may be an option.