This article is a guest contribution by David Rosenberg, Chief Market Economist, Gluskin Sheff.
BANK OF CANADA POLICY MUSIC — SHOULD I STAY OR SHOULD I GO?
We are within 24 hours of the most important Bank of Canada policy meeting in well over a year. In some sense, it seems like an easy forecast to make seeing as all the economists that toil for the Bay Street banks are forecasting a rate hike tomorrow and the money markets are almost priced the entire way for such a move. The reason why everyone is bracing for the first interest rate increase the country has seen since July 2007 is because the Bank of Canada purposefully set that universal expectation in motion when it decided not to drop the reference in its last post-meeting press release back on April 20, 2010 to its long-standing pledge to maintain its accommodative posture at least through to mid-2010.
A lot has changed since that time.
There is no doubt that the vast majority of the economic releases before the last press statement, and since, reveal an economy that has sustained the rock-solid momentum oh so evident in that eye-rubbing 5.0% burst of GDP growth in the final three months of 2009. There is also no doubt that underlying inflation is a tad higher than the Bank of Canada thought it would be when it dropped the overnight rate to 0.25% just over a year ago.
But much of the data digested by the central bank, the markets and economists are all backward looking and monetary policy should really be undertaken by looking through the front window as opposed to the rear-view mirror.
If you go back to the summer of 2007, you will see that the coincident indicators of economic activity were firm, but the leading indicators contained in financial market signals were telling central banks to cool their jets on any future rate hikes; think of the mistake it would have been for the Bank of Canada to have carried out any more tightening moves back then.
Policy rates are at “emergency” levels and, at 0.25%, is not sustainable. The problem with raising interest rates is that once a central bank embarks on that path, it’s a tough task to talk the markets out of pricing in a whole cycle of increases. It’s like eating potato chips — you can’t stop at just one.
So this is not just about raising rates once — once you start, the markets will begin to do the hiking for you as a central bank, which is why mortgage rates have already started to rise sharply in advance of the Bank of Canada doing anything. It was what the Bank recently said — or more like it, what it didn’t say — that has already prompted financial markets to jumpstart the rate cycle.
In my view, it does not make sense for the Bank at this point to start raising rates since there is no much uncertainty over the economic backdrop given the recent events in Europe and the contagion risks globally. The solid recovery view may still be intact, but it is far less of a sure thing than it was the last time the Bank of Canada met and tried to convince the markets that a rate increase was imminent.
The stock market has been weak and volatile, and there is a very good chance that a new bear market has begun. Corporate bond spreads have widened materially, de facto raising the costs of capital and doing a good part of the Bank’s job already if tightening financial conditions is the primary objective going forward.
Commodity prices have weakened precipitously from their recent highs and this is not only a deflationary development but will also cut into corporate profits. And we still have not yet seen the full deflationary impact of the 22% runup in the Canadian dollar over the past year. But the key in all this is that risk premia have risen across the planet, and when that happens, businesses tend to put their spending and hiring plans on hold. Of course, the exact opposite happened this past year, but what is done is done and monetary policy must be forward-looking. The financial markets, as leading indicators of economic activity, are signaling a slower growth profile ahead.
