Wednesday, 15 July 2015

Bank of Canada Rate Cut Appropriate

Just a quick update to indicate that, in my opinion, the Bank of Canada's 25 basis point rate cut to 0.50% was quite appropriate.

I had recommended that the BoC cut to 0.50% as early as last March and again recently when the C.D. Howe Monetary Policy Council met last week.

Why do I think it was appropriate? To update the analysis from my recent post titled "Equilibrium Real Policy Rates: Does Anybody Really Know", the Taylor Rule for the appropriate policy rate, as cited recently by Fed Chair Janet Yellen is:
The current policy rate (R) should = the equilibrium real policy rate (RR*) + core inflation (π) + 0.5 * the gap between current inflation and target inflation (π - π*) +      0.5 * output gap (y).
Today's Monetary Policy Report provided the inputs required to calculate the appropriate policy rate. Using assumptions, along the lines of those used by Ms. Yellen, that the equilibrium real policy rate is close to 0% currently; that the underlying trend in inflation is assessed to be 1.5 to 1.7% (p. 15) and that the Canadian output gap is -2.2% (p. 20), the current policy rate should be 0.30% or (0 + 1.6 - 0.2 - 1.1), or slightly lower than the 0.5% that the Bank of Canada set today.

With the economy clearly in a marked slowdown and with a federal election looming in October, the Bank of Canada was wise to take out additional insurance to bolster the economy now.  If growth recovers strongly later this year, the BoC may eventually be in a position to reverse the quite appropriate easing that has been provided since January. 

1 comment:

  1. The Canadian economy's never closing output gap! It will be interesting to see what sectors will do the heavy lifting going forward. Credit extension through the banking system can only get us so far as it is bringing consumption forward while our demographics certainly don't bode well for growth to return to a long term trend rate.

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