Wolf argues that, for many years, Canada has enjoyed a virtuous cycle: rising commodity prices fuelled a strong Canadian dollar, which boosted confidence, purchasing power, borrowing, consumer spending, housing prices and other asset prices. Now that virtuous cycle has turned vicious; all of these forces are working in the other direction.
Some economists argue that the negative effects of lower oil prices will be more than offset as US and Canadian consumers get a boost from cheaper gasoline prices and Canadian exporters benefit from a lower Canadian dollar.
But Wolf contends that most economists and markets are underestimating the second and third round effects: the vicious cycle of falling commodity prices, a weakening Canadian dollar, falling confidence, slowing borrowing, falling asset prices and weakening spending that will follow the crash in oil and other commodity prices.
As the economy and asset prices weaken, Wolf argues, "the probability that the Bank [of Canada] does eventually have to put interest rates back at zero has increased substantially". He suggests that, "The Bank of Canada does have a bit of room left to stimulate, although it will likely be hesitant to use it in the near term, partly to avoid the risk of exacerbating the household imbalances that have grown much larger since the crisis."
I believe that, in this debate, David Wolf's view is more likely to prove accurate. While I am in broad agreement with his assessment, in my opinion, he fails to mention one important link in the virtuous cycle that has turned vicious. When the price of oil [and other commodities] falls, Canada's terms of trade (ToT) weakens. When the price of commodities falls relative to the price of other goods and services, the price of Canada's exports falls relative to the price of its imports.
When the commodity terms of trade weaken, Canada's gross domestic income weakens. This negative shock to income is shared across the corporate sector, the government sector and the household sector. While some energy consuming industries will benefit, total corporate profits will fall. Government revenues will fall, causing most governments to curtail discretionary spending. While commuters will benefit from lower gasoline prices, the lower Canadian dollar will make imports of finished consumer goods and services more expensive. As housing and other asset prices weaken against a backdrop of record high household debt-to-income ratios, consumers will be reluctant to spend any windfall bestowed by lower energy prices. Many will prefer to save rather than spend the temporary boost to disposable income.
What is noteworthy about the chart above is that the depreciation of the Canadian dollar, significant as it has been, has not kept pace with the deterioration of the commodity terms of trade. Even if oil and other commodity prices stabilize at current levels, the Canadian dollar needs to fall further, to below 80 US cents (or alternatively USDCAD needs to rise above 1.25), to have a chance to offset the negative impact of the terms of trade deterioration on growth and inflation.
The Bank of Canada will make a policy rate decision and release an updated projection for the Canadian economy on January 21. The biggest change will be in the inflation projection. The table below shows the Bank of Canada's Total CPI inflation projection made in its October Monetary Policy Report (MPR) and JP Morgan's latest Canadian inflation forecast which incorporates most of the recent decline in crude oil prices.
The JP Morgan forecast anticipates that CPI inflation will turn negative in 2Q15 (as I predicted here) before edging back toward 1% by 4Q15 assuming that the price of oil rebounds toward $90 per barrel by the end of 2015. If, as I believe likely, crude oil prices remain depressed for a much longer period of time, say well into 2016 or 2017, inflation will likely fall into negative territory in early 2015 and remain there for some time.
With such an outlook, the Bank of Canada needs to pay full attention to defending its inflation target and supporting inflation expectations around 2%. The most effective way to do this in the near term is to provide guidance in the January 21 policy rate announcement and the Monetary Policy Report that the BoC stands ready to cut the policy rate if inflation moves persistently below the 1-3% target band.