Stephen Poloz and the Bank of Canada shocked markets this week by dropping the target overnight rate by 0.25%. In my previous post I spoke about all the reasons that the BoC would likely be raising the rate at some point this year; you can go back and read that if you like. This is a long post so you might want to go get a beer before you start reading.
Bank of Canada’s Policy Shift and Stephen Poloz
Before we get into the effect this is going to have we should say that on page one, paragraph one of the “How to be a Central Banker” handbook it says do not shock the market. Mark Carney made a habit of being boring and predictable and everyone praised him for it. They liked it so much they drafted him into the big leagues at the Bank of England. Avoiding this shock alone was a good enough reason to delay this rate change.
Forward guidance is the term used for when a central bank indicates ahead of time what it is likely to do in the near future and in the long term. It helps markets decide what they are going to do in response. Calm, collected responses. When the US Fed says it will not change rates until unemployment is below X%, that is forward guidance. Poloz has said that risk assessment is the new way forward for the BoC. Yes, forward guidance has worked well for us in the recent past but now we are going to try something new. In October he might have dropped a hint that most people (including myself) missed.
Some of you may be wondering why we aren’t being more specific about the likely future stance of monetary policy. Let me answer by saying that forward guidance remains a key element of the policy tool kit – but one that we will reserve for times when we believe there are net benefits to its use. There will no doubt come a day when we will offer forward guidance again – but not this day.
But more importantly he said this in September.
We have begun putting our growth and inflation forecasts in the form of ranges rather than points, and have given even more prominence to uncertainty and risks in the Monetary Policy Report. We have refined our analysis of financial stability risks and raised the profile of our Financial System Review. And, we have begun to offer a more fulsome description of how those risks are entering our policy deliberations. These changes have brought more transparency to policy decision making, and our policy narrative has shifted from one traditionally seen almost as “mechanical engineering” to one now characterized as “risk management.”
Why is that important? Well with the rate changes today it indicates that possible or perceived risk is now the most important thing when the BoC makes policy decisions. In this week’s announcement press conference Poloz said this.
Accordingly, we decided that it was appropriate to take out some insurance against that downside risk in the form of a lower interest rate profile. Policy insurance is a logical part of our risk management framework. Today’s action is intended to reduce the risk that our inflation path might move materially to the downside, as well as cushion the impact of lower oil prices and facilitate the economy’s sectoral adjustment to its new circumstances. The Bank has room to maneuver should its forecast prove to be either too pessimistic or too optimistic.
So now interest rates are an insurance policy against possible future risk and this is the new framework, got it. Also, you will notice that this statement basically says that lower rates are not out of the question. I would hope at least they have a model that is predicting this and that their nice precise model would tell them how much of a cushioning effect this rate cut would have. Because thinking that a central bank has a great model that lets them see things that the commoners do not is part of the game they must play. What does Poloz have to say about this?
Please, for the love of god, STOP CALLING IT INSURANCE!
Although mortgage rates should follow long term bond rates rather than be tied directly to the overnight rate we can expect to see lower mortgage rates sometime next week. It only takes one bank to set everyone off. Ratehub is currently showing 2.18% as the best 5 year variable and 2.69% as the best 5 year fixed rate. This means that we could be seeing sub 2% variable rates. If you are looking to buy a house this is good news. If you are at the CMHC and you are trying to cool the real estate market with tighter lending rules, sorry, you can go to hell. All those predictions of bubbles bursting in Vancouver and Toronto will have to be pushed back again. Calgary could certainly run into some problems in real estate so maybe his is a good thing for them.
From the press conference this week.
Finally, we discussed the risk that by moving today we would surprise financial markets. We generally prefer that markets not be surprised by what we do, and believe that transparency around our analysis of the economy will minimize the scope for surprises. In that respect, we took comfort from the observation that the consequences of the drop in oil prices appear to be well understood, and that the possibility of a rate cut had begun to enter markets in the last couple of weeks. Moreover, given the magnitude of the shock, we concluded that the benefits of acting now rather than waiting would outweigh the costs of any short-term market volatility that might arise.
Our dollar dropped 3 cents versus the US dollar immediately. So the markets had not already priced this in. At all. We are glad you discussed it though.
We will have to wait until this month’s total data is in for the CERI fluctuation but I imagine the Canadian dollar dropped everywhere. (Less so against the Euro)
Trade and Local Prices
A weaker dollar means that all of our exports are cheaper. This is good for our GDP.
It means that we will not see gas prices as low because our weaker dollar buys less on international markets.
Inputs to manufacturing are more expensive assuming they come from other countries. Any capital investments in machinery or other equipment that need to come from other countries is now more expensive.
Almost all consumer goods are more expensive. Electronics, clothing, some food. Anything not made in Canada is now more expensive.
If I was a journalist (Like, a real one, not a guy with a website) I would probably put in a freedom of information request for all communications over the last few months between the government and the BoC. Why?
Government delays budget because oil prices are sagging and they need more time to balance the books. If only there was a way to boost exports to pick up the slack from those low oil prices to help reach the promised balanced budget.
BoC drops the interest rate when markets are expecting a hike within the year and what do you know, the currency tanks. This is good for exports! What a coincidence.
The BoC would never manipulate the currency like that. After all in September Poloz said,
A floating loon is a thing of beauty, and so is a floating loonie, at least from this economist’s perspective.
How can you not trust an economist that talks like that?
When interest rates are low, people take on debt. When interest rates are low for a long time people take on a lot of debt.
That is why on December 10th Poloz said.
Let me just add a few comments specific to the most important risk discussed in the FSR: the difficulty that highly indebted households would have servicing their debt if they were to face a sharp decline in their incomes or a sharp rise in interest rates. This situation raises the risk that a shock to the economy could trigger a correction in house prices. The probability of this risk materializing is low, but if it did occur, the effect on the economy would be severe.This risk would be greater if house prices were judged to be overvalued relative to fundamentals. … Although there is considerable uncertainty around this question, various approaches – including our own – suggest that there is some risk that the housing market is overvalued, and our estimates fall in the 10 to 30 per cent range.
Yeah so Canadians really need to get their debt under control. Now lower interest rates should allow you to pay down more of your debt but unfortunately most people see it as a chance for cheap borrowing. But since this is all caused by lower oil prices what did Poloz say about that this week?
Canadian consumers will spend less on energy, but they could save some of the windfall rather than spend it
Fools! You are trying to save the money you are not spending on energy since the price in oil dropped? Well that is bad for the economy. Lower interest rates! Borrow more!
The fact that he sees money not spent on energy as a windfall says a lot here.
We’re in one. More on that in a dedicated post to come later.
As mentioned, shocking the market is not a good move for any central banker unless you have a specific goal in mind. I do not think this is a great move but I do not have access to the data sets or models that the BoC does. Their 25 page Monetary Policy report reads as if it was written with a rate freeze in mind and then edited at the last minute so it made more sense with the rate decrease. I would really like them to try to justify their decision a little more clearly but then again I think there are only a handful of people that read the MPR when it is released anyway.
Personally, I was floored by the announcement. I really expected a freeze. I will be keeping an eye out for lower mortgage rates and if I see something at or below 2% then it will be time to call my banker.