I have been away for a few weeks but I am now back to posting regularly. Enjoy!
At the beginning of the month the Bank of Canada decided they would raise the overnight rate by 0.25% to 1% total. Standard complaints were heard on most of the forums that I read. Why would the bank raise the rates when our economy is slowing down? I guess that is a valid question and one that I had asked before right on this page I am pretty sure. We need to remember that interest rates of 0.25% or anything similarly low are emergency rates. These are not rates that we should be keeping for any longer than we are required to. Sure our economy might not be growing as fast as we would like but 1% is still a low number compared to everything in the recent past. Remember that in the 1980s interest rates were much higher; they spiked over 20%. People’s heads would explode if the rates were at 20% these days. Why, they would need to save up money to buy things! Outrageous!
I guess I should bring up the fact that inflation was much higher back then as well. The BoC only began its policy of holding a 2% inflation target in 1991. So in 1989 when inflation was at somewhere around 5%, the interest rate was something like 12%. This makes the real interest rate 7%. Nowadays the country runs at a pretty constant 2% inflation but we have an interest rate of 1%. This means that any money that is being held is actually losing value. This is of course one of the ideas behind a low interest rate, to encourage people/firms to spend and boost the economy but there needs to be a distinction between encouraging spending and penalizing savings. Now I do understand that we are talking about the overnight rate(you can looks through past posts or do a search if you are not clear on what that means) but the number still provides a good picture of the differences between the past and present.
I believe that the BoC decided some time ago to raise the rates to at least 1.25 % before the end of the year and only with the increasingly bad numbers coming out of the US did they even begin to indicate that they might stop at 1%. If there is a “double dip” recession as the media loves to predict then we need to have room to move our interest rates. Right now the US have nowhere left to go, they are at rock bottom rates. The only tool the Federal Reserve really has left is quantitative easing. With a slightly higher rate the BoC is giving themselves some room to move should a second dip occur.
There is also something to be said about the real estate market in Canada. If you read any major newspaper or magazine you would have to believe that the market is going to implode in the near future. Higher interest rates can curb that as well but I won’t get into that just yet. Soon, but not yet.
So July 20th has come and gone and the Bank of Canada decided it was a good idea to raise interest rates %0.25. This brings the total overnight rate to %0.75, still very low. Now I know that the BoC has access to more information about the state of the economy than I do but it’s almost as if they didn’t read my earlier post at all. Don’t they know they have to wait six months to see what the last increase in the interest rate did to the economy? Seems like if they were going to do a 25 point increase and then another 25 points a month later they should have just done a full 50 point increase initially. I think we call all feel safe that they do have some kind of plan. Oh wait! They told us their plan!
Here is the summary. http://bankofcanada.ca/en/mpr/pdf/2010/mprsumjuly10.pdf
Here is the full report. http://bankofcanada.ca/en/mpr/pdf/2010/mprjuly10.pdf
The full report is long and boring of course but the summary is short and boring so it might be worth the read. The summary of the summary is that the recovery is proceeding at a slower than anticipated rate but it is still looking good. The rate went up to make sure inflation stays in check but it is still low so the stimulus remains in place. We will need to be careful about how we change our rates in the future as the economic recovery of the world is uncertain.
I did predict a rate freeze but I guess I got caught up in idea of what higher rates vs. lower rates do to a system without considering the actual level of current rates. Even after the increase rates are still very low. Lesson learned.
I have also decided to update more often. Right now I am doing one post a week, I will increase to at least two posts a week. Rejoice! I will also try to diversify the topics a bit more.
Well it’s July now and that means that we are approaching the next Bank of Canada announcement. On July 20th they will announce if they will raise interest rates again or not. In June when they were making their announcement it was basically taken as given that the rate would increase. At the time inflation was just over target and economic growth was looking good as well. The rate was raised by 0.25 which everyone expected. This allowed the markets to return to normal operation as it reestablished the operating band.(See the May 28th post if you forget what this is)
At the end of my earlier post on interest rates I mentioned the market lag. Many people read the summaries of interest rate changes and think that it all seems pretty easy. Economy doing bad, put rate down to boost demand. Economy doing well, put rate up to cool it off. It has been established in Canada that any change in the overnight interest rate does not fully impact the economy for six months. This of course makes it much more difficult to know exactly how your changes will affect the economy. What if you predict a strong market and decide to cool it off with higher interst rates only to find that six months later there is an unexpected shock to the system? Now you have a system under shock and your decision to cool things off seems terrible because it amplifies the problem. It works the same in the other direction of course.
Jobs are looking good in Canada with StatsCan reporting that the Canadian unemployment rate dropped below 8% this week. We have recovered almost all of the jobs we lost in the recession. This is of course great news. A recovery ususally comes in the form of higher GDP first and then later, the return of jobs. So everything is looking good. Many people expect the bank to raise interest rates again on the 20th. This month it is a little bit different however. This time two days after the BoC releases their decision on interest rates they release a Monetary Policy Report. This lets us commoners know what Carney and crew are thinking. So we are looking at two possible scenarios.
1. Rates go up 0.25%. Report says the economy is looking strong and the time has come to raise interest rates so that we will have a cushion for any future problems. There will likely be some statements about how the inflation targetting and interest rate adjustment worked well and that our system is functioning as it should. Rightly so, if everything continues as it has been Canada is looking pretty damn good coming out of this.
2. Rates stay the same. Report says the economy is looking good but we have to be cautious as the world comes out of the worst economic slump since the Great Depression. It will mention that while the rates look good for now it can easily be readjusted again in September. The next chance to raise rates is September 8th,2010.
According to the BoC website core inflation is sitting at about 1.8% right now. Slightly lower than they would like. This is a tough choice but Phil’s prediction of the week is choice number two. We want to keep demand cranking so I don’t it is quite time to slow things down. I could see a higher rate September.
The Americans are back in a growing economy but their jobs have yet to recover and now there is talk of austerity measures. If they start cutting spending too soon it could mean big trouble for their economy. Trouble for them is, of course, trouble for us.
Tomorrow is July 1st! HAPPY BIRTHDAY CANADA! In order to celebrate we are going to implement a new style tax in Ontario. HST. Harmonized Sales Tax. Noone ever likes to hear the words “new tax” and the words usually cause people to go into a foaming-at-the-mouth tirade against whatever current government is implementing it. In some cases however the idea behind the tax and all the steps that have been implemented with it are not entirely obvious to all the people the new tax will affect.
Let’s go over the main idea behind the tax and why the government thinks it is a good idea. The main idea is that it decreases the amount of tax that companies will pay on input goods, the materials they use to make other goods and then resell.
That is, there will only be tax on the value added. This means goods that firms use as inputs all become cheaper. Where they used to have to pay tax on everything they used to make their products now they don’t. What this means is that all goods become cheaper to produce. When goods become cheaper to produce they become cheaper for the consumer. This is not a short tem effect, meaning that it is going to take some time to kick in. This is probably what has people the most upset. All they see is that some things that they only paid one low tax or no tax on before now have the full 13% of the HST. Being upset is understandable, that is why the provincial government lowered everyone’s income tax last year and why they are sending out checks to people. You get more if you are a family versus an individual. The natural reaction to this is to say there is no way the firms are going to pass the savings onto the consumers! Maybe not right away, but they will. That is the nature of a firm, to maximize profits. Let’s drop a little game matrix down here and we’ll take a look at the likely outcome. Let’s make some assumptions before we start. These assumptions help us to simplify the model.
There are only two firms that make jewellery, Phil’s Gold Shop and Dalton’s Gold Shop.
Customers know the price of items at both shops at all times.
There is no collusion between the firms
So what we are saying is that if one firm lowers their price then all the customers will go to them to purchase goods.. This is going to be a hyper quick lesson on basic game theory. (The only kind I know) Please look at this table.
We see the possible outcomes for the two jewellery companies when they either keep their prices high or drop them as their costs drop. Notice that if one firm drops their price even a small amount they capture the entire market. The first number is the profit Dalton makes and the number after the comma is what Phil makes in each set of circumstances. The units don’t matter. So here is the quick reasoning that Phil might go through.
- If Dalton keeps his price high and Phil keeps his price high they each make 6.
- If Dalton keeps his price high and Phil lowers his price then Phil makes 10 and Dalton makes 0.
- Phil is better off lowering his price if Dalton sticks with the high price.
- If Dalton lowers his price and Phil keeps his price high then Dalton makes 10 and Phil makes 0.
- If Dalton lowers his price and Phil lowers his price then each will make 5.
- Phil is better off lowering his price if Dalton lowers his price.
When the best choice in both cases is the same this is referred to as a dominant strategy. This is the strategy that the firm will use. Phil will lower his price. It is easy to see that Dalton will do the same.
I do realize that this is a very simple model but it is with simple models that we can begin to understand why certain elements of the market react the way they do on a larger scale. If there was collusion between the firms and they both kept their prices high then yes, they would make more money and prices would be higher but if just one person lowers their price (remember in the real world there are many more firms in each market) then it triggers a whole series of prices drops until firms are back to making normal levels of profit but with the lower cost of inputs. This means prices go down. Lower input costs normally mean that firms hire more workers as well, but thats a whole other graph that I won’t show here.
The HST is obviously a vastly more complex issue but there are lots of places to read about it and I try to keep things a little different around here.
Back in March the Bank of Canada announced that inflation in Canada had risen to 2.1% for February. As I have mentioned previously, the Bank of Canada targets an inflation rate of 2% right on. Something must be done of course! This may not seem like a large difference but the expected inflation rate was lower. What to do and why? (Is answering my own questions a valid literary style? Yes it is.)
Eight times a year the Bank of Canada announced any changes it might make to the target overnight lending rate. Here is the schedule for 2010
The overnight rate is the rate at which banks loan each other money if they need to borrow funds from one another when all the accounts clear at the end of the day. Right now the overnight target is sitting at 0.25%. This is as low as it can go. There is what is called an operating band around the target rate of 0.25%. This means that at the end of the day the Bank of Canada(BoC , laziness kicked in) pays 0.25% less than the target rate to banks on any deposits they have left with the BOC. It also charges 0.25% more than the overnight rate to lend money to the banks. This of course means that overall the rate at which banks loan to each other should fall right in line at the target rate. This may seem a bit confusing because the current rate is so low. Currently the rate that the banks get on their deposits and the target rate are the same. This is not the normal situation so consider an easier example. If the BoC were to set the overnight target rate to 4% then it would lend money to the big banks at 4.25% and pay 3.75% on all deposits left at the end of the day. At the current rate, banks do not want to leave money in the BoC because they would get 0.25%. This means that they put their money somewhere else in the market. This is good for the economy, yay!
Now the problem is that with low interest rates, there is more money on the markets. This means that our friend inflation rises. Since inflation is the BoC’s main target they need to do something about it.
Here where it gets interesting (for some) in the next little while. Since inflation is a bit too high and the overnight interest rate is the tool to control it, we can expect higher interest rates in the near future. This means that June 1st we should expect a rate hike of at least 0.25%. Since the inflation rate has slowed since February/March(the high level was in part because of the Olympics) the amount of the rise on July 20th is more uncertain. It will likely be from 0 to 0.5%. What this means is that the banks raise their lending rates which slows spending over the entire market.
I will talk a little more about the lagged effects on the market and how the exchange rate is affected by interest rate changes in the next couple of days.
Edit: Originally I posted that the banks got paid 0% on their deposits when the target rate was at 0.25%. This was incorrect and was fixed on June 1st.
If Canada found itself in a situation where it was no longer competitive with the US we would need to take action to solve this problem. “No longer competitive” means that someone could get the same products made elsewhere for cheaper or more efficiently. They could hire workers in the US for the same or lower amount of money and get their goods produced. Any goods that are produced in this uncompetitive version of Canada are done so at high cost and so must be resold at higher cost. This is obviously not good.
As discussed previously Canada has a floating exchange rate. So if this situation arose one possible solution would be to devalue our currency. This means getting more Canadian dollars on the market so that they are worth less. This means that the average Canadian worker does not see a change in the amount of money that appears on their paycheck(nominal wage) but the value of that money is actually less(real wage). So as the real value of Canadian dollars gets lower, Canadian goods become cheaper and people buy our stuff.
With a fixed currency like the Euro this is not an option. Greece cannot devalue its currency because it does not control it. So as Greece tries to recover from its problems it must find a way to become competitive in the Euro and world markets. They need to grow their GDP but they have no way to reduce the real wages in the country. This of course means that they are going to have to reduce real and nominal wages. This means that people have to take actual pay cuts. As you can imagine it is alot easier for a government to devalue a currency than to tell people they are all taking a pay cut. People are not too happy about it, obviously.
I am sure there will be much more to say. The EU has recently decided to setup a massive a financial safety net, I have not read all the details so that will maybe be discussed in the future.
What is going on in Greece? Lots of things. There are so many articles on the situation in Greece that I thought it would be a good idea to add to the noise with my own little bits of information. Before we can ask what is happening in Greece I think we need to understand what the Euro is exactly. Yes, it’s the EU’s currency. That is easily understandable. What is not clear to many is people is why the EU members chose to adopt a common currency in the first place. There are advantages and disadvantages to doing this and when the Euro was adopted all the members obviously decided that the benefits outweighed the shortcomings and the world got the Euro. A common currency has:
– Resources that are normally used to convert currency between countries that do a lot of trade can be used in more productive ways. This saves all the currency conversions that would need to take place everyday as goods/services moved from country to country. Trade goes up!
– Stable monetary policy. In Canada since 1991 we have enjoyed very stable monetary policy. Our central bank shoots for a 2% inflation target and has been able to keep it close. Smaller countries with less stable governments or central banks do not enjoy this same privilege. High inflation or unstable monetary policy in general leads to an unpredictable market. Investors don’t like unpredictable and so they stay away. With one central bank to control policy for all EU countries the idea was that it would bring stability.
– Purchasing power. Since the market using the currency is larger it creates a larger market for goods/services to be sold in. This is supposed to lower prices.
– No floating exchange rate. Floating exchange rate is what Canada has. Our dollar can move against the US dollar and all other currencies in the world as people feel our country is more or less desirable for investment or they want more/less of our goods.
– No national monetary policy. In Canada, the bank of Canada decides how much money to print. Meaning that they control inflation. With a common currency like the Euro all members of the union must agree that they want the same level of inflation. Imagine if Canada and the US started using some new common currency, let’s call it the Loonback. A bank would be set up to give out the Loonback at a certain rate. Right now Canada sets a 2% inflation goal, the US has no official target other than to keep prices stables. The Loonback bank would need to have some policy that makes both countries happy. This can be a good thing but if one country finds itself in a situation where it needs to devalue its currency and can’t, bad things can happen.
More on this in the near future. I promise not all posts on this site will be this boring.