Ambler, Kronick - Uncertainty Clouds the Path of Monetary Policy
From: Steve Ambler and Jeremy M. Kronick
To: Bank of Canada Governing Council
Date: Sept. 7, 2018
Re: Uncertainty Clouds the Path of Monetary Policy
The Bank of Canada announced this week that it was leaving its overnight target rate unchanged at 1.5 percent. No surprise: the C.D. Howe Institute’s Monetary Policy Council had recommended no change, and forecasters did not predict one. Markets understand that the Bank is on a path of gradual rate hikes, and despite solid economic news, there is too much uncertainty clouding the outlook. Unfortunately, much of that uncertainty clouds business investment and exports – the components most critical to Governor Poloz’s desired “rotation” of the Canadian economy away from household spending.
The intense focus on central banking post-crisis can convey the impression that the Bank moves rates based on what happened in the news in the last 24 hours. It sets the overnight rate in order to achieve inflation at its 2-percent target six to eight quarters from today. It does use current data to update its forecasting models, to better predict the overnight rate consistent with target inflation. But by definition, central banking takes a forward-looking approach.
Why is this important? With output growth rebounding to a robust 2.9 percent, and headline inflation surprising on the upside in July, at 3 percent year-on-year, a hike in rates might look appropriate. However, the large increase in consumer prices was driven by temporary factors such as increased gasoline prices. The Bank’s three measures of core inflation, which take out the most volatile components of the consumer price index, were all at or close to 2 percent. The spike in headline inflation did not imply a continuing overshoot of the target.
The Bank undoubtedly has a base-case scenario for future increases in the overnight rate target. However, the uncertainties surrounding this base-case scenario are greatest when it comes to business investment and exports – the key pieces to Governor Poloz’s stated desire to see the Canadian economy shift away from consumption.
The announcement itself noted that data on both business investment and exports were choppy but the rotation was proceeding. We are not so sure.
Take business investment. The fall in business investment as a result of the 2014 oil price collapse has only partially reversed, even as investment in the US and other OECD countries picks up. And in late-breaking news, just after the federal government assumed responsibility for the expansion of the Trans Mountain pipeline, at a cost of $4.5 billion to Canadian taxpayers, the Federal Court of Appeal blocked final approval of the project.
Not only are those who had an economic interest in the pipeline affected – workers, investors, government – but it shines a negative light on Canada’s regulatory environment, making us look unattractive for any prospective investment projects.
Uncertainty over the path of investment is a two-edged sword for monetary policy. It can cause both actual and capacity output to fall. If both fall, then the direction of the change in the output gap, the difference between actual and capacity output, is unclear. This ambiguity creates a big challenge for monetary policy.
How about exports? NAFTA negotiations between the U.S. and Canada have restarted this week, and several sticking points remain: dairy supply management, the dispute settlement mechanism, government procurement, steel and aluminum tariffs, and the timing of any sunset clause. A failure to reach an agreement would have profound implications for the Canadian economy, especially in crucial sectors such as the automotive industry.
Trade uncertainty affects expectations for the path of Canadian exports, an important component of aggregate demand. And, while a depreciation of the Canadian dollar could cushion some of the blow, it would also increase import prices, thereby increasing inflation. So a potential scenario is an economy in reverse with rising inflation – a very uncomfortable environment for central bankers.
The Bank of Canada was right to hold rates steady, despite headline inflation above target, and an economy humming along. Too much uncertainty in critical areas remains. Central bankers must be forward looking. As should we all.
Steve Ambler is a professor at the University of Quebec at Montreal’s management school, and holder of the David Dodge chair in monetary policy at the C.D. Howe Institute. Jeremy Kronick is Associate Director of Research at the C.D. Howe Institute.
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The views expressed here are those of the authors. The C.D. Howe Institute does not take corporate positions on policy matters.