Negative Interest Rates for Canada?

Guest post by Norman Mogil


Introduction


In his December 8th speech, the Governor of the Bank of Canada, Stephen Poloz introduced the possibility of negative interests as a policy tool . He was adamant that the Bank was not embarking upon this policy, rather it was exploring the implications of using such an unconventional policy instrument in times of economic shock or major dislocations. It was his view that  " it's prudent  to be prepared for every eventuality " (1)

Yet, his discussion went beyond just academic musings and into the practical  realm of how would negative interests  impact  the Canadian financial markets . In 2009, the Bank  looked at  the application of  negative interest rates ,but  rejected  it as a possible tool. What has changed since that time that  caused the Bank  to come out in favour of such an unprecedented policy move?

I believe there are two important developments that go a long way towards explain the shift in the Bank's thinking  towards the " unthinkable".

First, the Canadian economy has weakened further since mid-2015, raising the spectre of a rate cut to revive growth; negative rates are just another form of rate cutting.

Secondly, the experience with negative rates in the Eurozone and in the EU in general has proven to be more positive ( less to be feared) than many experts thought early on; some half dozen countries now experience negative rates and continue to function without  major market disruptions. Before we look at Canada, specifically, it is helpful  to explain  why some  central banks chose to establish negative rates.

Why Go Negative

Negative interest rates are introduced for one of two reason.  In the case of  Switzerland, it  had to manage  a very sharp and sudden  upward pressure on Swiss Franc ; investors were fleeing the Euro  and  the sudden  capital inflows from the Eurozone   drove the  value of Franc to dangerously high levels.   In  the case of Sweden, the   country was facing  serious deflation and an ensuing recession ; the central bank  turned to this unconventional policy to reverse this trend.  The Eurozone adoped negative rates  to combat both deflation and a weak economy.

Canada's recent economic performance continues to face serious headwinds.

*  GDP growth over the past 12 months stands at 1% annualized;

*  Unemployment has remained stubbornly high at 7%

*  Consumer prices are increasing at no better than 1% yearly, well below the target rate of 2%;

* WTI oil prices have fallen to around $35bbl ( and Canadian oil sells at a further discount to as low as $22 bbl); and,

* Our balance of trade continues to worsen; non-energy exports have not filled  the gap created by the loss of oil export revenues.

Although the Bank continues to express optimism about the near term , it fully recognizes that there is a significant output gap ( as high as 1.5%) that will not be closed before 2017, at best. Given the most recent economic data mentioned above, closing this gap remains a very tall order, indeed.


A New View on Negative Rates

In 2009 the Bank believed that it should not drop its policy rate below 0.25%. It maintained that zero or negative rates were be too disruptive to money market funds, resulting in large money outflows and a reduction in liquidity; both would harm the smooth operations of the credit and equity markets. As for the market for long term financial products, there was a real concern that life insurers and pension funds would not be able to match their long term liabilities, if yields on long term bonds fell to below investment requirements.

Recent research by the Bank's staff have turned up evidence to the contrary. In a  discussion  paper by Bank staff, it is  argued   that " negative policy interest rates do not appear to have caused significant volatility...the transmission has been swift... through the exchange rate". Also," money markets have continued to function smoothly.....as long as there is a positive spread to encourage borrowing and lending". And, the paper concludes simply by saying that "recent experience indicates that negative interest rates are indeed a viable policy tool."

This research report has given the Governor the confidence to state that " the Canadian financial markets could also function in a negative interest rate environment".
It seems as if  there is,  almost,  a feeling of relief that this unconventional tool has come out of the realm of academia and into the realm of real world policy making.

More significantly, the Governor stated that the " effective lower bound for Canada's policy rate is around minus 0.5%". In other words, there is considerable room for the bank rate to be lowered to stimulate growth without any adverse impact on the functioning of our financial markets.. It seems that the door is now ajar  the regarding  the introduction of negative rates in Canada.

Canada has  already experienced negative rates of return, as measured by the  real rate of interest. The average yield on Government bonds in the 3-5 year range , when discounted for inflation, reveal an average real rate of minus 0.3%  .Granted that real rates over time vary considerably depending on inflationary expectations, the fact that we have been accustomed to zero or below zero real rates since the 2008 crisis, makes any move towards  nominal  negative rates not as disruptive to the financial markets as once feared. Moreover , the real rate of interest has been well below the average of  1-2%  that has prevailed over many years in the industrialized world.

A final word. In a very recent interview, Ben Bernanke  suggested  that 'negative rates are something the Fed will and probably should consider if the situation arises,” .It seems that there is some meeting of the minds that negative nominal rates  are no longer unthinkable.

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Notes
1)  Stephen Poloz, "Prudent Preparation: The Evolution of Unconventional Policies" ,The Empire Club of Canada. Dec 8,2015)


2)  Harriet Jackson," The International Experience with Negative Policy Rates"  The Bank of Canada. Staff Discussion 2015-13

3)  MarketWatch, Dec 15, 2015

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Watch the Fed's RRP facility uptake jump at year-end

The Fed's policy announcement to raise rates had one technical detail that didn't get much media attention but is actually quite important. The reverse repo (RRP) rate was not only raised from 5bp to 25bp but the Fed also removed the cap on the RRP facility (which was at $300bn). It means that the program participants such as banks and money market funds can place nearly unlimited amounts of liquidity with the Fed overnight and earn 25bp. For now the Fed made $2 trillion of treasuries available for the RRP operations.

This sets the overnight riskless rate at 25bp which becomes the floor for the Fed Funds rate (and other money market rates such as commercial paper and private repo).

The immediate demand to place overnight funds with the RRP facility has been relatively modest at $143bn (note that we should see the reserves at the Fed drained by the uptake amount in the next H.3 report).

Source: NY Fed

Instead of using RRP, many market participants are enjoying the tightness in the private repo markets as general collateral (GC) repo now clears about 20bp above the RRP rate. The key reason for this relatively elevated spread is the increased regulatory pressure on banks to cut back on their balance sheet usage.

Source: DTCC

However the RRP demand is expected to spike at year-end as banks focus on window dressing. Given the somewhat elevated level of market stress and no cap on the RRP facility size, the uptake will be particularly large this time as we saw at the end of Q3 (note that the chart below shows the total reverse repo held by the Fed, which includes RRP).

Source: St. Louis Fed

Some are concerned that given the pressure on banks' balance sheets, this shift to RRP could disrupt the private markets on December 31st and send the GC repo rates to new highs.







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The Fed will hike the Fed Funds target range by 25bp but the rate will rise by only 20bp

Given the upcoming FOMC meeting, it's worth revisiting some of the mechanics around the rate hike. The FOMC is fully expected to lift the Fed Funds target range by 25bp - from 0-25bp to 25-50bp.

The current Fed Funds rate is around 13bp. Does it mean that after the FOMC meeting we will see the rate at 38bp, exactly 25bp above the current level? A number of analysts don't think so. Here is why.

In theory banks lend to each other overnight at a rate that on average should equal to the Fed Funds rate. However interbank lending has declined sharply after the financial crisis as banks rely on other sources of financing.

Source: St Louis Fed

A great deal of the overnight activity these days comes from the Federal Home Loan Banks (FHLBs) who often place their excess liquidity with commercial banks. They do this because they don't receive interest on reserves as private commercial banks do. Instead they place excess funds with commercial banks in order to receive some non-zero rate. That interbank rate however has to be some amount above the riskless overnight rate in order to make these transactions worthwhile for the FHLBs. That riskless rate in this case is based on the Fed's RRP (see post), with the latest auction setting at 5bp.

Source: NY Fed

The current spread between Fed Funds and the RRP is about 8pb and some view this spread as remaining relatively constant immediately after the hike. The FHLBs' demand to place liquidity will keep the Fed Funds rate at the lower portion of its range but at this minimal spread (8bp) above the RRP rate.

This week the Fed will be taking the following action.

Source: Morgan Stanley

With the RRP rate going up to 25bp and the spread to Fed Funds remaining constant, the new Fed Funds rate would move to 33bp. And that is 20bp (not 25bp) above the current level.

As a result of this projection, the calculation for the rate hike probability implied by the Fed Funds futures would need to change. Instead of being around 79% (chart below), which is based on the 25bp assumption, this week's rate hike probability is closer to 98% (based on the 20bp increase). The December 16th liftoff is now fully priced into the markets.

Source: CME

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Canada Need Not Fear Deficit Financing

Guest post by Norman Mogil

As the new Liberal Government takes shape, all eyes will be focussed on how it proposes to finance its ambitious agenda . Deficit financing will be at the centre of all discussions concerning jobs and economic growth over the next five years. In its latest Economic and Fiscal Update (November, 2015), Canada's Finance Department recognizes  the damage that has already occurred from plunging commodity prices, the deterioration in the country's terms of trade and the worldwide slowdown . The major question facing the Government is:  What is the capacity of the Federal finances and the Canadian economy to meet this challenge?


Fiscal Outlook

The Parliamentary Budget Office(PBO) and Finance Canada each produce a fiscal outlook to 2020-21 based upon existing government policy at the time. On balance, there is no material difference between the two forecasts over the next 5 years. PBO average annual  deficit is  $2.9 billion, ; the Government annual average  deficit is $2.7 billion. However, there is a sizable difference in the fiscal year  2020-21. The Government projects a surplus of $ 6.6 billion while the PBO anticipates a deficit of$4.6 billion . The Government forecasts assume a more optimistic forecast for revenues personal and corporate taxes as well from the GST ( national sales tax) .

As with all forecasts, the further out one goes the less reliable are the projections in either direction. For our purposes, we will use the Government’s projections for the period as a whole as a benchmark with which to explore the capacity of the Canadian economy to manage Federal deficits. The analysis would not be materially different had we adopted  the PBO figures.

Table 1  is a summary of the fiscal outlook to financial year 2021 prepared by Finance Canada, the department responsible for the national budget.  These projects use the former ( Harper) Government fiscal 2015 fiscal framework, update to November 2015. None of the new (Trudeau) Government policies are included.

A couple key metrics standout. First,  over the next three years ( 2016-19) the Federal annual deficit will average about 0.1% of GDP--- well within the  comfort zone and not out of line historically. Expected economic growth, although modest over the  next 5 years, will likely provide sufficient revenues to absorb the annual deficits so that the level of outstanding  Federal debt at the end of period remains largely unchanged. Second, the   Federal debt outstanding  as a percent of GDP actually falls slightly  from 31% in 2015/16 to 25.2% by 2020/21.  By way of    comparison ,the 2021 forecast  represent the lowest ratio  in over  30 years. ( see Chart 1).

     

Canada has always been well-received in the capital markets at home and abroad ; bond auctions continue to be  well covered and receive firm bids.  More importantly, as Chart 2 demonstrates, the entire Canadian government yield curve has shifted downwards in the last 12 months , a reflection of low inflation expectations and confidence in the quality of the security sold. Of late, there has been shift towards issuing longer dated bonds to take advantage of the falling long term rates ( 10-30 year terms). Accordingly, the weighted - average rate of interest on public  market debt has fallen to 2.37 per cent in 2013–14 ; this average  interest rate  still stands above the current yield  for long bonds. Thus, any additional long-term issuance will  contribute to a further  reduction in average cost of refinancing.

The IMF refers to fiscal space  as " the room in the public sector budget  that allows government  to
provide resources for a desire purpose without jeopardizing the sustainability of its financial position". Canada is  in no way jeopardizing the Federal budget  by running these anticipated deficits; the size relative to GNP and the servicing costs are well within acceptable range.. More importantly, should the fiscal restraints be relaxed to accommodate additional borrowing aimed at developing infrastructure projects, these projects have the potential to add to future revenues and thus  pay for themselves over the longer term.

Comparison to US Stimulus Programs

Parliament opens the first week of December at which time Canadians will learn more of the programs and policies that will constitute the Federal budget and hence the anticipated future deficits. At this point we can assume that the Liberal's platform , featuring infrastructure spending,  individual spending programs, and  tax changes aimed at the redistribution of income will be at the centre of the next Federal budget. The Liberal party’s  platform  anticipates a budget deficit not to exceed $10 billion in any year.

American readers  should note that what is proposed by the Canadian  Government is quite different from  the American Recovery and Reinvestment Act, 2009( Stimulus Bill ) . That bill was designed  as an emergency measure to kick start the US economy after the financial crisis of 2008. The main thrust was tax relief for  the individuals  and corporations to save and create new jobs;  a much small component included  spending on new infrastructure . A secondary goal was to provide immediate relief to those state and local governments hardest hit by the steep recession. Both countries have adopted a Keynesian approach to stimulate growth; the principal difference is that the US program was conceived as an emergency situation to stop the economic free fall of 2008; the Canadian programs are designed to add to and sustain growth over a longer term.


Shifting  the Burden to Fiscal Policy

Prior to the 2008 crisis and recession, the Federal Government was running budgetary surpluses; in 2009 all that changed  and Ottawa immediately shifted towards deficit financing.  However, within a year the previous Conservative ( Harper) Government adopted a policy deficit reduction by  “starving the beast”, a deliberate policy of squeezing revenues ( reduction in the Federal sales tax, GST) and cutting public expenditures ( Chart 3).  By 2014 the deficits had virtually disappeared. During the recent election campaign arguments were advanced that this relentless reduction in the deficits came at the expense of economic growth.

With the advent of the Trudeau Government  deficits will now  shift the burden to stimulate the economy away  from monetary policy. The Bank of Canada , like all central banks , has been active in reducing the cost of borrowing; in 2015, alone, the Bank rate has been cut from 100 bp to 50bp ,largely in response to the swift decline in oil prices and the serious slowdown in the Canadian economy, especially in the  spring and summer months. Moreover,  monetary policy has been aided by the  30% decline Canadian  dollar over since 2013. However, monetary policy can do only so much to promote growth. Now, fiscal stimulus  will be added to the  growth policy mix.


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A contrarian perspective on the short euro trade

As the euro continues to drift lower, it has become the accepted wisdom that we are headed for parity with the dollar.

Source: barchart.com

Indeed it is widely expected that the ECB will expand its securities buying program in size, duration and scope (the ECB has been exploring buying municipal bonds for example). The central bank is also expected to cut the benchmark rates, pushing deeper into negative territory. The chart below shows the Euribor futures trading significantly above par as the market expects sharply lower interbank rates.

Source: barchart.com

This of course differs sharply from the monetary policy in the US where markets now assign 70%+ probability of a rate hike next month (as discussed here back in October). There is no question that such divergent policy trajectories should push the euro lower. But has a great deal of this divergence been priced into the markets?

As the Euribor chart (above) shows, the market could now be "priced to perfection". The expectations for a "bazooka" new stimulus from the ECB are also manifested in the record low Eurozone bond yields. For instance, here is Germany's 5-year government bond yield which is clearly pricing in much more demand ahead.

These expectations have resulted in the short euro position becoming a crowded trade once again. The chart below shows speculative accounts' net euro futures positions. What happens if the announcement from the ECB is not quite the "shock and awe" that markets expect?

Source: Investing.com

What could push the ECB to come out with a more modest stimulus increase? Here are some possibilities.

1. In spite of the VW scandal and the Paris attacks, German business sentiment remains strong. The Ifo industrial sentiment exceeded economists' forecasts while the service sector climate hit record highs (below). While the China slowdown certainly created a drag on German GDP growth, the impact has not been as severe as many economists were expecting.

Source: Ifo

2. Moreover, we are seeing significant fiscal stimulus from Germany as the nation's government is addressing the refugee influx.

Source: Deutsche Bank

3. At the Eurozone-wide level we see the composite PMI also beat consensus, touching multi-year highs. The ECB has been known to monitor such PMI indicators.

Source: Markit/Tradingeconomics.com

4. The euro area credit situation is improving, albeit gradually. The deleveraging in the banking system has been over for some time as loan balances continue to grow.

Source: ECB (adjusted for sales and securitization)

We can see signs of stronger bank lending showing up in the Eurozone's broad money supply, which increased more than expected.

Source: Investing.com

5. Finally, the euro area's core CPI rose more than consensus in the latest report. While this is still far from the ECB's target, some central bankers looking at the chart below may want to pause before introducing massive amounts of new stimulus.

Source: Investing.com

This latest core CPI report will therefore increase pressure from some of the more hawkish council members to proceed with a more modest/gradual program when introducing new stimulus.

Jens Weidmann (FT): -  The core inflation rate stands at 1% and should gradually increase towards our definition of price stability, which is – let me remind you – a medium-term concept.

Crucially, the decline in oil prices is more of an economic stimulus for the euro area than a harbinger of deflation.

Lower oil prices reduce energy bills for both households and firms. That frees up financial resources which can then be put to use elsewhere – for consumption, investment or for reducing the debt overhang. All of this is good for the economies of the euro-area countries.

There is no question that the fundamentals for the euro remain bearish, especially vs. the US dollar. However, given some of the trends discussed above, a contrarian approach would suggest more caution on that crowded short euro trade.


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 Canada Need Not Fear Deficit Financing

As the new Liberal Government takes shape, all eyes will be focussed on how it proposes to finance its ambitious agenda . Deficit financing will be at the centre of all discussions concerning jobs and economic growth over the next five years. In its latest Economic and Fiscal Update (November, 2015), Canada's Finance Department recognizes  the damage that has already occurred from plunging commodity prices, the deterioration in the country's terms of trade and the worldwide slowdown . The major question facing the Government is : to what extent can it  undertake deficit financing to achieve its economic goals.? What is the capacity of the Federal finances to meet this challenge? 

Fiscal Outlook

 Table 1 is a summary of the fiscal outlook to financial year 2021 prepared by Finance Canada, the department responsible for the national budget.  Their budget projections used the former (Harper) government’s 2015 fiscal framework , updated to November, 2015. None of the new government's revenue or  expenditure programs are included.

Table 1  Fiscal Outlook

A couple key metrics standout. First,  over the next three years ( 2016-19) the Federal deficit will average 0.1% of GDP--- well within a comfort zone and not out of line historically.  Expected economic growth, although modest over the  next 5 years, will likely provide sufficient revenues to absorb the annual deficits so that the level of Federal debt at the end of period remains largely unchanged.

Second, the Federal debt as a percent of GDP actually falls from 31% in 2015/16 to 25.2% by 2020/21.  Comparing these levels of debt/GDP , the levels represent the lowest in over  30 years, especially in periods of good economic growth in the latter half of the 1990s. ( see Chart 1).  .


Chart 1   Federal Debt as % of GDP






          


 Canada has always been well-received in the capital markets at home and abroad ; bond auctions continue to be  well covered and receive firm bids.  More importantly, as Chart 2 demonstrates, the entire  Canadian government yield curve has shifted downwards , a reflection of low inflation expectations and confidence in the quality of the security sold. Of late, there has been shift towards issuing longer dated bonds to take advantage of the falling long term rates ( 10-30 year terms). Accordingly, the weighted average rate of interest on public  market debt has fallen to 2.37 per cent in 2013–14 ; this average rate , now stands above the current yield  for bonds  10years and up. Any additional long-term issuance will  contribute to a reduction in refinancing risk at a low cost .


Chart 2



The IMF refers to 'fiscal space' as " the room in a government's that allows it to
provide resources for a desire purpose without jeopardizing the sustainability of its financial position" . Canada is  in no way jeopardizing the Federal budget , given the low interest rate environment. More importantly, should the fiscal restraints be relaxed to accommodate additional borrowing aimed at developing infrastructure projects, these projects can  pay for themselves over the longer term.

Comparison to US Stimulus Programs

 Parliament opens the first week of December at which time Canadians will learn more of the programs and policies that will constitute the Federal budget and hence the anticipated future deficits. At this point we can assume that the Liberal's platform , featuring infrastructure spending,  individual spending programs, and  tax changes aimed at the redistribution of income will be at the centre of the next Federal budget. The platform  anticipates a budget deficit not to exceed $10 billion in any year.  

American readers  should note that what is proposed by the Canadian  government is quite different from  the American Recovery and Reinvestment Act, 2009( Stimulus Bill ) . That bill was designed  as an emergency measure to kick start the US economy after the financial crisis of 2008. The main thrust was tax relief for  the individuals  and corporations to save and create new jobs;  a much small component included  spending on new infrastructure . A secondary goal was to provide immediate relief to those state and local governments hardest hit by the steep recession. 






 

 

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Eurozone reacts to anticipated fed rate hike

Guest post by Marcello Minenna


Almost without warning, the Eurozone government bonds and the Euro experience spikes in volatility this past month. These abrupt movements are clearly correlated with the mayor announcements of a change in monetary policy by, initially by the ECB and then, by the FED. The European banks had been actively pursuing front-running strategies which try to anticipate ECB's moves until the beginning of Quantitative Easing program (PSPP). Not always with success, as experienced with the “flash crash” of April and June. The new game plan spectacularly backfired with the hawkish statement of Ms. Yellen during the FOMC of the 28th of October. This igniting a massive sell-off of Eurozone bonds with an intensity comparable to the previous “flash crashes”.

At the October 22 meeting, Draghi has clearly anticipated an acceleration of the monetary easing policies. He hinted at cutting the deposit facility rate (now at -0.2%) by at least 10 basis points and at increasing the pace of asset purchases. Finally, the ECB strongly suggested that the PSPP program may be extended for another 6 months. Both policy moves were designed to counter a strengthening Euro.

Figure 1.

In August it has become apparent to the European policy makers that a stronger Euro was having an adverse effect on the Eurozone’s balance of trade (Figure 2), thus harming the export driven recovery envisioned by the ECB.

Figure 2.

Since a rising currency was not seen then with favor by the ECB, the market began to evaluate a further monetary easing by the ECB as very likely, especially a reduction of the ECB deposit facility rate. This, in turn, resulted in the European banks resuming their hoarding of government bonds and pushing yields to very low levels in the following month. Even issues characterized by negative rates slipped below the deposit facility rate (Figure 3) thus becoming ineligible for the ECB purchase under the PSPP.

Figure 3.

This buying behavior would have made sense only if banks were expecting an interest rate cut. In fact, only bonds with a yield higher that the deposit facility rate are eligible for PSPP purchases: by lowering the deposit rate, the ECB is automatically widening the pool of purchasable bonds. In this scenario, the owner of the now eligible bonds would have been in the best position to exploit the jump in the value that one should expect due to the increased demand, as the ECB steps in.

Evidently, the chance of a rate cut was in the air. After the Draghi declarations, markets experienced a manic buying that has depressed yields to deep negative levels never experienced before (Figure 4 and Figure 5).

Figure 4.

Figure 5.

Clearly traders were pricing in the hinted cut of at least 10-15 basis points and were taking long positions on the short part of the Eurozone government term structures. The EUR / USD weakened accordingly, down of 20 pips.

Then, something happened that European banks were not expecting . At the FOMC meeting of 28th of October, MS Yellen released a hawkish view; expectations of a rate hike were brought forward to December. This can be easily appreciated by looking at the probability of a rate rise as inferred from the Futures' Prices on FED Funds (Figure 6). In a single day, the odds of a rate hike surged from 35% to 50%.

Figure 6.

This sudden reversal, from the previous FOMC meeting in September, had a clear impact on both the Euro and the ECB interest rate policy. The EUR / USD slipped another 20 bps; almost, instantaneously, the currency fell below the threshold of 1.1. This renewed trend towards a weaker Euro (-7% in two weeks, Figure 7) has unintended consequences for the front-running strategy of European banks: in fact less pressures on the exchange rate have given immediately more room to the ECB to delay or partially scrap the idea of a “QE on steroids”. Suddenly, the strategy of storing ineligible bonds with deep negative rates to front-run the future (but not so certain anymore) deposit rate cut was no longer attractive to Eurozone banks. A selling spree ensued immediately after Ms. Yellen’s speech.

Figure 7.

This pattern was further reinforced after the release of the stronger than expected data on unemployment and payrolls in the US for October. Traders adopted a 70% probability of a US rate hike in December. Predictably, the EUR / USD took another hit downwards of almost 20 bps. The sell-off of Eurozone bonds with negative yields accelerated in the following days (Figure 8).

Figure 8.

What will be the probable dynamics of the Eurozone government bonds in the coming weeks? As the ECB proceeds with the QE program, the pool of eligible assets will continue to shrink at a rapid pace; it’s not a case that the ECB is considering for purchases also municipal bonds issued by the main European cities. The illiquidity of a contracting market and the ever-changing expectations about the delivery of a QE 2.0 will surely put Eurozone bonds under further stress in the coming weeks.


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Canada's Growth Potential: Tempering Our Expectations

Guest post by Norman Mogil


Introduction

How fast can the Canadian economy grow? What can Canadians expect now that commodity prices have plunged and the country is running a trade deficit?

These questions take on greater significance with the shift in political power to the Liberals who campaigned on growth through fiscal stimulation and government deficits.  Government revenues are tied closely to a nation’s capacity to growth; higher incomes provide room to stimulate the economy without generating deficits. This blog discusses Canada's potential  and expected growth against weakened commodity prices, a slowing international economy, and accompanying deflationary pressures.

Estimating a nation's potential GNP is simple: combine yearly changes in the labour force  with yearly changes in labour productivity. More workers and greater efficiency increases potential output. The gap between potential and actual GNP growth is the unemployment rate. Falling short of potential growth results in underemployment.


What is behind Canada's Poor Economic Performance

Both Canadian labour force and productivity have grown by 0.9% annually. The combined growth of 1.8% , however, is insufficient to provide full employment; unemployment averaged 7.2% over the period well above conventional estimates of full employment around 5%.

Changes in the labour force are basically predetermined by demographic trends, but changes in productivity are quite variable. Capital investment and technological innovation affects the efficiency of every worker. Human capital in the form of worker skill and experience also generates greater labour efficiency.

While Canadian capital investment varies from year to year, investment has steadily declined over the past few years.  The trend is for increases in  capital expenditures to continue to decline, especially in the resource sector. This steady reduction in the growth of investment contributes to the mediocre labour productivity.

One reason for the slowdown in capital expenditures relates to capacity utilization. As long as there is excess capacity, a corporation does not feel compelled to expand its facilities. Chart 2 shows the persist decline in the capacity utilization rates for Canada. Lower operating capacity means lower output levels and a reduction in the work force. The combined effect of low capacity utilization and jobs losses puts Canada even further below its potential growth path.   

On the demand side, Canada continues to struggle. Gross Domestic Product over the past 12 months has increased by just 1%; industrial production rose only 0.6%; and the unemployment rate moved up slightly to 7.1%. Canada continues to operate below potential in part because domestic demand is insufficient to restore economic growth.


Destroying Capacity

This has been a major concern of the Bank of Canada (BoC). In its October 2015 Monthly Policy Report, the BoC raised the issue of how capacity continues to be destroyed.

The BoC points out that the boom in commodity prices since 2001 generated strong investment in the extraction sector, increasing demand for labour, raising wages, and attracting workers from other sectors. This significantly raised production capacity, especially in Western Canada.

However the energy sector's expansion resulted in other sectors contracting. Over the same period,  non-energy sectors struggled mightily against the appreciating Canadian dollar.  Industry Canada estimates that 300,000 manufacturing jobs have been lost in Ontario and Quebec since 2004. The BoC argues that "in the non-resource traded-goods sector, firm exit was widespread and some physical capacity was destroyed which would, therefore, be not available for subsequent expansion." Estimates for the amount of destroyed capacity range as high as 5% of total economic capacity.


The Canadian Association of Petroleum Producers estimate that in 2015 the industry will suffer 150,000 job losses. Furthermore the industry expects losses to continue and lowered its production forecast by 20% for 2030 because of large cuts in capital investment (Bloomberg News, Oct 29, 2015).

Canada’s productive capacity is experiencing a ‘double whammy'. Non-resource sectors have a long way to recover from a higher Canadian Dollar in 2001-14, and now the resource sector must contend with 'blowback' from the collapsing commodity markets. In sum, the nation's industrial capacity has been whipsawed and potential growth remains constrained.

Viewed differently, the cumulative effect of more than a decade of industrial capacity reductions has taken a heavy toll on the nation's growth potential. Underinvesting reduces growth capacity, and idle workers reduce cannot develop the skills and experience necessary to improve productivity. Together, weak capital and labour reduce long term growth prospects.


Future Potential

What are the near- to medium-term prospects of enhancing Canada's potential?

The BoC believes that "in the current environment, declines in investment in the resource sector are occurring faster than increases in investment in other sectors… the differences in timing  of the response… imply that potential output growth is more likely to be in the lower range of estimates." In a word, our expectations have to be tempered.  The BoC estimates that the best the economy can generate is growth of 1.8% annually and that will still result in about 1.5% slack each  year until 2017 .The danger lies in continuously growing below potential. That implies that there is continuous underinvestment, slack in the labour market, and a general underutilization of available resources. Should these conditions persist, then potential will decline further.

Concluding Remarks

1. Canadian growth potential has been lowered in large part because of dramatic changes in the world markets for our goods , both energy and non-energy.

2. Non-energy firms need to improve their competitive positions and take advantage of the lower Canadian dollar with greater exports.

3. The resource extraction sector will continue undergoing painful adjustments as it aligns future capital investment to meet the reduced demand for oil, gas, and other commodities.

4. The big issue concerns the fiscal side. As the economy adjusts to slower growth, the concern is that governments at all levels will be challenged to generate revenues to meet voter expectations for new expenditure programs. Yet without greater fiscal stimulus the economy will not be able to return to move positive growth path.

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The China Path - (What recent events in China tell us about the way forward) by Matt Garrett

The China Path">

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The possibility of a 2015 rate hike in the US should not be ignored

Futures-implied probability of a 2015 rate hike in the United States remains below 40%. Some market participants have all but dismissed this possibility as they look at weak global growth as well as soft inflation and inflation expectations in the US. Some have even suggested that the next policy move by the Fed should be a rate cut into negative territory.

Source: St. Louis Fed

However global growth and US inflation expectations may not necessarily the main focus at the Fed. For example, numerous economists continue viewing the energy market crash as having only a transient impact in inflation. The logic here is that if we freeze crude oil prices at current levels (below $45/bbl), by early 2016 the year-on-year change will be around zero.

And a number of energy analysts expect crude oil prices to begin gradually rising going forward. To many forecasters this would imply that crude oil price weakness will no longer have such a severe impact on the rate of inflation.

Of course some would say that low fuel prices have not yet fully made their way through the economy - suggesting that the disinflationary pressures will persist for some time. Similarly some argue that the full effects of the dollar rally in the first half of 2015 are yet to be fully felt.

Nevertheless many economists view the headline inflation approaching the core measures by early 2016, with the core CPI turning higher as well. Moreover, a slew of recent US economic reports suggests that while the US economy probably slowed in the second half due to dollar strength and weakness abroad, the effect may be transient.

The housing market for example continues to recover and consumer sentiment and spending does not seem to be impacted by the recent market volatility.

Source: St. Louis Fed

Source: Scotiabank

Source: @GallupNews

Source: Deutsche Bank, @MKTWeconomics

Even US manufacturing which has been under pressure recently is showing signs of stabilization. The latest Markit manufacturing PMI report surprised to the upside.

Source: Markit, Investing.com

But what about the relatively poor payrolls report for September, which clearly missed expectations? Some economists argue that this is as much about slower hiring as it is about tight labor markets. For example (as we saw in the latest Pulte Homes quarterly report), the homebuilding industry is struggling with acute labor shortages. Of course as the Wall Street Journal recently pointed out, the US housing correction has been so severe that a whole generation of construction workers has permanently exited the industry, creating shortages as the sector recovers. Nevertheless when the Fed hears about labor shortages in an industry such as housing, they take notice.

Source: WSJ

Signs of tighter labor markets have also appeared in the latest NFIB reports on small business. When speaking with small businesses it becomes clear that there is no shortage of applications for each opening they have. But they can't seem to find people with the right experience and/or skill set (skills gap).

Source: NFIB

Moreover, the broader unemployment measures continue to improve. Here is the so-called "U-6" for example, which according to some economists is about 1% away from "full employment" (see quote).

Source: St. Louis Fed

Whatever the case, many argue that this is a precursor to acceleration in US wage growth. We haven't seen a great deal of evidence of that so far, but many economists (including those at the Fed) are convinced that it's only a matter of time.

One of the concerns the FOMC had in September was the risk of a rapidly deteriorating economy abroad, particularly in China. It has since become clear that while China's economy continues to slow, the combination of aggressive fiscal and monetary stimulus there is likely to cushion the decline.

Source: Investing.com

Some may remember that in September of 2013 in the wake of the so-called "taper tantrum" the Fed decided to continue with QE. The central bank however started tapering three months later. The "playbook" this time around could be similar.

Are global markets prepared for a December liftoff? It seems that while credit markets remain cautious, there is much less uncertainty priced into US equity markets. A relatively strong employment report next week for example could reignite market volatility.

Source: BAML

Many argue that the US economy can withstand a rate hike at this point. Indeed it can. However, given that much of the world is currently in a monetary easing mode, such a move by the Fed would result in a further rally in the US dollar. We saw the Bank of Canada strike a dovish tone recently, the PBoC is in the middle of a major easing cycle, the BoJ is in a perpetual QE, and the ECB is fully expected to expand its stimulus.

A further dollar rally would exacerbate the rout in emerging markets, potentially forcing China to resume the RMB devaluation. Disinflationary pressures in the US could worsen and the manufacturing sector would take another hit. Nevertheless, it seems that many at the Fed are willing to overlook such an outcome and begin the first rate hike cycle in nearly a decade.



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