As such, I canât help but think that it would be premature for the Bank of Canada to begin the process of ânormalizingâ interest rates at this time. Yes, yes, there is a case to be made that the current interest rate setting is at an âemergencyâ level and that the economy is no longer in need of such a huge degree of monetary stimulus. I buy that. I also donât think anyone would want to detract from our economic achievements of the past year, including the recent announcement from Statistics Canada that our recession officially ended in Q3 2009. The economy has certainly exceeded almost every oneâs expectations, including mine.
But we are still to a large extent digging ourselves out of a deep hole. Even with the improvement in economic activity, real GDP is still more than 2% lower today than it was two years ago at the peak and is actually no higher now than it was in the opening months of 2007. Think about that for a minute before we start to uncork the champagne over our economic progress â the level of real GDP hasnât budged in three years. Nominal GDP is down 2.5% from the pre-recession peak. Yes, employment has improved markedly but when you look at the big picture, there has been practically no net job creation since late 2007 even though the population has expanded by 1 million since that time. Manufacturing shipments are currently some 20% below their pre-recession levels as well. On second thought, perhaps the current interest rate landscape is appropriate for an economy that is still operating so far below where it was two years ago.
In the final analysis, the Bank of Canadaâs primary mandate is one of ensuring that the economy operates as close to price stability as possible. Last I looked, the unemployment rate was stuck above 8% even with the improvement in labour market conditions and when all underemployment is included in the data, such as discouraged workers who are not officially counted in the workforce, the unemployment rate is actually closer to 12%. Maybe this is why the Canadian wage rate â the 12-month change in average hourly earnings â has been shaved from over 4% a year ago to 2% today.
The inflation rate is also comfortably below 2%, as has been the case consistently since November 2008. Producer prices have deflated by over 1% in the past year and we have yet to see the full effects kick-in from either the strong Canadian dollar or the recent downdraft in commodity prices.
Indeed, I remain of the view â and admittedly in the minority in this country â that the primary risk is one of deflation, not inflation. A quick read of the FOMC minutes from the last Fed policy meeting shows that a growing number of policymakers south of the border are leaning towards this view as well. To wit:
âPolicymakers anticipated that both overall and core inflation would remain subdued through 2012, with measured inflation somewhat below rates that policymakers considered to be consistent over the longer run with the Federal Reserve's dual mandate ... participants noted several factors that likely would continue to restrain expansion in economic activity and posed some downside risks.â
The Fed is willing to acknowledge the deflation risks as well as emphasize the downside economic risks, which is why it is likely not going to touch rates for a long while. The Canadian economy does not operate in a vacuum and we are not isolated from global events, as we saw in 2008 and early 2009. Even before the deflationary shock emanating from the European debt crisis, and even in the face of an economic rebound of its own, the Fed was stressing the need to maintain an accommodative policy stance because the future is highly uncertain â more than what is typical coming out of recession â and that this recovery is more fragile than meets the eye and vulnerable to a policy mistake. My hope is that the Bank doesnât make one as it did in 2002 when it last tightened prematurely.
Source: Breakfast with Dave, May 31, 2010 (PDF, Easy registration required, worth it.)
Copyright (c) Gluskin Sheff
