The next Bank of Canada monetary policy decision is three weeks away, and is coming at a time when talk is focused on when central banks will tighten their accommodative policies prompted by the global health crisis.
The Bank of Canada was the first off the mark in reducing its monthly asset purchases on April 21.
The global economy is off to a better start than expected this year, prompting some discussion about excess demand overwhelming supply.
The Bank of Canada has been a leader in working with central banks around the world in response to the pandemic. Our RSM Canada Financial Conditions Index, which has averaged more than one standard deviation above neutral, strongly confirms the Bank of Canada’s aggressive response.
But economic conditions have started to change, and the Bank of Canada was the first off the mark in reducing its monthly purchases of securities on April 21. Governor Tiff Macklem announced an adjustment in the bank’s quantitative easing program “to a target of $3 billion weekly net purchases of Government of Canada bonds. That is down from a minimum of $4 billion per week.”
The governor added that the adjustment “to the amount of incremental stimulus being added each week is consistent with the progress toward economic recovery we have already seen” and that it would maintain the term structure (i.e., the maturity distribution) of its holdings.
In our estimation, the reduction in bond purchases does not signal the end of quantitative easing, but more a fine tuning that corresponds to an economy in the process of reducing an inordinate amount of slack.
We also think it is unlikely that the Bank of Canada would consider raising its policy rate off the zero bound at this point or even in the near future. Here are four reasons why.
The third wave
First and foremost, the third wave of COVID-19 infections is not yet over. Yes, the number of newly reported cases recently dropped by 1,000 a day from its peak on April 18 of 8,800. But it will be weeks or months before we can be sure that vaccinations have outrun the spread of infections, particularly if the variants are not quickly contained.
The inflation rate is up, but there is a reason why
The headline inflation rate increased to 2.2% in April, but that’s only because 2020 was so awful.
By April of last year, the supply shock caused by the global shutdown of commerce had morphed into a demand shock, with consumers huddled in their homes and spending limited to essential purchases.
So the latest headline Consumer Price Index is only 1.6% higher compared to February 2020, the month before the pandemic. Note also that the Bank of Canada’s measure of the core rate of inflation – excluding energy and fuel — remains at 1.4%.
The Bank of Canada has said that it will retain its policy of accommodation for as long as necessary to sustainably achieve its 2.0% inflation target. The bank considers low inflation a symptom of a struggling economy. We expect the bank to allow the inflation rate to rise above its 2.0% target until the recovery is established.
As to the effect of the bank’s adjustment to its bond purchases, the yield on 10-year government bonds is 1.52%, virtually unchanged since the announcement. Just as prompting inflation back to normal levels is likely to take time, it will be equally difficult to move interest rates out of their decade-long decline.
The recent peak for the 10-year was only 2.3% in late 2018 as the U.S. trade war took hold. Reviving subpar growth and overcoming the slack in the economy will take more than a few months of low money market rates.
Labor market conditions are improving
The unemployment rate of 7.5% in March was still too high and it jumped back to 8.1% in April. While those are significant improvements from the 13% rate of last year, there’s a long way to go in terms of temporary and permanent displacements, particularly for low-paying employment.
Just before the pandemic, the unemployment rate had dipped as low as 5.6%. But even if the economy were to reach those levels, that leaves out too many members of the labor force.
Outside of keeping investment costs at a minimum, there isn’t too much that monetary policy can do to increase employment opportunities. It remains for the fiscal authorities to provide child care, education and the training necessary to develop an advanced economy.
Financial conditions are set to accommodate growth
Commodity prices have moderated in recent weeks such that financial conditions are no longer signaling an asset bubble. There is less need for the bank to change course than there was a month ago.
Because central banks have determined that monetary policy is transmitted to the economy through financial conditions, we have created the RSM Canada Financial Conditions Index to measure the degree of risk or accommodation priced into financial assets.
A value of zero indicates a normal degree of risk priced into financial assets. Values below zero indicate an abnormal degree of risk. Values above zero indicate an accommodative environment for investment.
Our composite index has averaged just over 1.0 standard deviation above neutral over the past four weeks. That implies that financial conditions are conducive to investment, economic activity and a solid recovery this year.
Policy prescriptions
Finally, with inflation too low, and with unemployment too high, a simple Taylor Rule model of central bank behavior suggests that the Bank of Canada will most likely keep money market rates at a bare minimum, and will continue its presence in the bond market to pressure long-term interest rates lower.
The Taylor Rule holds that a central bank will lower its policy rate when there is slack in the economy – indicated by low rates of inflation and high rates of unemployment. The bank will raise its policy rate when an economy begins to overheat — indicated by inflation pushing too high — and a tightening of the labor market, indicated by a lower-than-normal unemployment rate.
At current levels of inflation and unemployment, the Taylor Rule suggests a negative policy rate, which translates into the Bank of Canada maintaining its policy rate at the zero bound.
Since the pandemic began, the Bank of Canada has worked to maintain liquidity in the money markets and to encourage investment by suppressing long-term interest rates. This is evident in the normalization of financial conditions that began last summer.
Because of its steady guidance, the bank has created a secure environment for investment and the confidence that it will do all it can to maintain that environment.
For more information on how the coronavirus pandemic is affecting midsize businesses, please visit the RSM Coronavirus Resource Center.
