The Bank of Canada Should Stay on Course

One year ago, I posted that "The Bank of Canada Should Open the Door to a Rate Cut". The following week, the BoC "shocked" economists and the business media by cutting its policy rate 25 basis points to 0.75%. I do not agree with those who say that it shocked the bond and currency market because those markets were already pricing about a 50% chance that a rate cut was coming in 1Q15.

A year ago, I focused on the likely impact the sharp drop in commodity prices (led by the collapse in crude oil prices) would have on the economy. I said,

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.

I noted a year ago that the Canadian dollar had weakened sharply, but that the depreciation had not kept pace with the weakening in the commodity terms of trade (which is simply equal to the Bank of Canada Commodity Price Index divided by the core CPI). The chart below updates this relationship.

The BoC's two rate cuts, in January and July 2015, combined with the US Fed's bias to hike rates, which it finally acted upon in December 2015, helped the depreciation of the Canadian dollar to keep pace with the continuing sharp decline in the commodity terms of trade. 

I don't think many people recognize that Canada's commodity terms of trade in January 2016 are 28% weaker than they were at the lowest point of the Great Recession of 2008-09. And the prospect today for a quick rebound is not there as it was in early 2009, when the shale oil revolution had hardly begun, when China and other emerging economies were growing strongly and when the G20 was in the process of applying huge coordinated monetary and fiscal stimulus to the global economy. Indeed, most G20 leaders have recently been more focussed on cutting fossil fuel consumption than on providing stimulus for global growth.

In Canada, new governments at the federal level and in energy-rich Alberta, have promised to act on climate change, to increase infrastructure spending, and have already raised top personal income tax rates (while lowering "middle-class" tax rates). The combined effect of these measures over the next few years is unlikely to provide much, if any, real stimulus to growth. Indeed, continued uncertainty over resource royalties, payroll taxes for government run pension plans, and carbon taxes or cap and trade policies to address climate change seem likely to act as further meaningful drags on business investment and real GDP growth. 

So the Bank of Canada should stay on course and cut the policy rate by another 25 basis points next week on January 20. 

This is the recommendation that I made to the Bank of Canada in my role as a member of the C.D. Howe Monetary Policy Council (MPC). Some members of the were reluctant to call for another rate cut because they were concerned that doing so could trigger a further sharp depreciation of the Canadian dollar. Several suggested that the currency could overshoot its' "fair value" to the downside. One even suggested that the BoC could trigger a currency crisis. 

In my opinion, these fears are way overblown. The depreciation of the Canadian dollar so far has just kept pace with the deterioration of Canada's commodity terms of trade. Ahead of the BoC decision next week, economists are about evenly split in their forecasts with an increasing number calling for a rate cut as commodity and equity markets weakened sharply over the first two weeks of January. The bond and currency markets have already priced in a better than 60% probability of another 25 basis point rate cut on January 20. If the BoC decides not to cut rates the Canadian dollar is likely to rally, preventing it from acting as the cushion to the terms of trade drop that it needs to be.

I would also point out that those arguing against a rate cut are mostly based in Ontario and Quebec. As we have seen in the past in Canada, regional views on appropriate monetary policy sometimes vary. Those in the non-resource regions of central Canada appear to want to have the benefits of lower crude oil and other commodity prices (in the form of lower consumer prices for gasoline and lower resource input costs for for manufacturing), but don't want to have to share the costs in the form of a weaker Canadian dollar that cushions the impact on resource industries but increases central Canadians' costs of imported food, Florida vacations and BMWs. 

BoC Governor Poloz (and the Governing Council) has pursued the same approach to monetary policy in the face of a severe commodity price shock that his predecessors Mark Carney, David Dodge or Gordon Thiessen would have followed. If the current Governing Council is concerned about the Canadian dollar falling too much, it should cut 25 bps to 0.25% and provide forward guidance that the policy rate is expected to remain at that level, conditional on underlying inflation remaining on a projected path back to the 2% target by the end of 2017.