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The Bank of Canada (BoC) released its latest Monetary Policy Report (MPR) last Wednesday.
always read this report with great interest because it gives us the
BoC’s views on the state of the world’s largest economies and includes
projections for where the Bank sees foreign and domestic economic
momentum headed over the next several years.
I have criticized several of the BoC’s recent MPR’s
as being wildly optimistic so I was interested to see this latest
version offer a much more cautious view. To be clear, I understand that
the Bank must always hedge its comments about our prospects with a
little rose colouring, given the influence that its words can have on
both our bond and equity markets. But whereas previous MPR reports
seemed to require the willing suspension of disbelief, the optimistic
tint in this latest version was left more to the margins.
Here are my two key takeaways from the report:
Bank finally dropped its tightening bias (which was more commonly known
as its repeated warning that interest rates would rise more quickly
than most Canadians were expecting).
This tightening bias
should have been removed long ago. We have been mired in a low-growth
world with no real threat of significantly higher inflation for longer
than that bias has been in place. It was obvious to everyone that the
Bank was using this warning as a form of moral suasion in an effort to
rein in household credit expansion. There was wide agreement that
actually tightening monetary policy to curb household borrowing rates at
a time when the broader economy actually needed looser monetary policy
would be like using a hacksaw for a job that called for a scalpel. This
view was repeatedly validated when Federal Finance Minister Flaherty
made four rounds of changes to our mortgage rules while the BoC stood
pat. Meanwhile, because borrowers weren’t buying the BoC’s threat of
higher rates the bias had no discernible impact on household borrowing
activity. But it did serve to prop up the already expensive Loonie and
may have caused some businesses to forgo capital investments they
otherwise would have made. That’s why many argue that the bias was doing
more harm than good, and as it rang increasingly hollow over time, it
also diminished some of the BoC’s overall credibility. For those reasons
it simply had to go. Good riddance.
2. The Bank now
believes that the recovery “will take longer than previously projected”
and its views on inflation imply that the Bank’s overnight rate, on
which our variable-mortgage rates are priced, will not be raised until
late 2015 at the earliest.
To wit …
“The output gap in the base-case projection is anticipated to close around the end of 2015.”
output gap is the difference between our actual economic output and our
potential economic output. When the output gap is wide, there is little
upward pressure on inflation. Conversely, when the output gap narrows,
the risks of higher inflation and higher interest rates rise.
“Total CPI inflation is expected to return gradually to target around the end of 2015.”
This is consistent with the output gap comment above.
[U.S.] Monetary policy remains highly stimulative, with members of the
Federal Open Market Committee expecting the first increase in the
federal funds rate to occur only in 2015.”
As I have written in many posts (here are my most recent comments on the topic),
the BoC can’t move its overnight rate until the U.S. Fed moves its
policy rate first, and while the Bank will never openly admit this, the
Fed’s timing will effectively dictate the BoC’s next tightening move.
the MPR report the Bank listed both the main downside and the main
upside risks to future growth. Here were the risks that were
highlighted, with my comments under each:
- A more protracted and difficult euro-area recovery.
that the euro zone’s leaders haven’t fixed any of the region’s
structural flaws, I continue to believe that it is still only a question
of when, not if, the next euro-zone crisis will occur. Also, I’m not
ready to hang my hat on the slight rebound in euro-zone growth that we
have seen lately.
- Weaker exports.
This MPR was
decidedly negative on the U.S. economy’s prospects and given that we
still sell about 80% of what we export into U.S. markets, weaker export
demand seems likely. Unless you think that the free-trade agreement we
just signed with the EU is going to swing momentum in our favour. In that case, it will probably
take a good couple of years before that agreement is finally signed and
approved by each individual country member of the EU (and see my comments above
on the euro-area recovery).
- A disorderly unwinding of household sector imbalances.
our house prices resume their sharp upward rise I think Mr. Flaherty
will announce more rule changes, such as raising the insurance premiums
charged on high-ratio mortgages or insisting that all mortgages be
qualified using a 25-year amortization. If this happens I will probably
continue to support Mr. Flaherty’s efforts, but that doesn’t mean I
won’t be worried that he is tempting fate. It takes time before the true
impact of regulatory changes like these can be known and the more he
tightens, the higher his risk of over tightening becomes. Of course, if
Mr. Flaherty does nothing to slow rising house prices, then the market’s
eventual unwinding of our house price-to-income imbalances could be far
- Stronger growth in advanced economies.
it just me or does it seem that the downside risk section of the MPR
should have been easier to write? I know there are some very smart
economic optimists out there and I read their viewpoints regularly. But
so far they just haven’t convinced me. In a world where most of the largest
economies are fuelling their growth (tepid as it may be) with a
combination of massive stimulus and ultra-loose monetary policy, I still
think that today’s global recovery is being built on sand.
- A quicker rebound in confidence and business spending.
suppose it’s possible but there is so much uncertainty in the world
that I don’t see confidence levels significantly rising any time soon. Here are some
examples of what I think will continue to hold business confidence and
spending in check: the U.S. fiscal and debt-ceiling fight, which is
merely pausing until January for an intermission; the if and when of the
Fed’s taper, which hangs over markets like the sword of Damocles; the
next round of euro-zone bailouts, which is imminent and could come with
protests, and possibly riots, in donor and donee countries alike;
Japan’s determined march toward 2% inflation, which will essentially bankrupt its government when achieved. I could go on.
I will give the BoC credit for the more cautious (and realistic) view
it offered in the latest MPR, its rose-coloured crystal ball is still
plain to see. The Bank continued to use its well-established habit of
downgrading its short- and medium- term growth forecasts and, as an
offset, compensating for this by upgrading its longer-term view. This is
an attempt to solve the problem of trying to maintain a neutral view in
tough times. As these forecasts draw nearer it becomes more difficult
to ignore reality, so the BoC’s regular forecast downgrades are
unavoidable. The MPR’s more optimistic longer-term forecast is then
crafted as reassurance to would-be optimists that brighter times are
still ahead. Never mind that these halcyon days have lately remained
fixed on the far horizon. The Bank is bound to be right eventually, and
in the meantime, they can keep leaning on their ubiquitous “margin of
error” qualifier to tidy up any overly optimistic forecasts as they move
closer to the present day.
Five-year bond yields were twelve
basis points lower last week, closing at 1.71% on Friday. Bond markets
liked that the BoC finally removed its tightening bias and bond yields
dropped on the news. Lenders continue to inch their five-year fixed
rates back down, but so far, mostly with promotions that offer
shorter-term rate holds for deals that are closing fairly quickly.
variable rates are being offered in the prime minus 0.50% range, which
works out to 2.50% using today’s prime rate of 3.00%. The BoC’s latest
MPR makes it increasingly likely that the Bank will not raise its
overnight rate for at least the next two years. In that event, the odds
that the variable rate will save you money over today’s five-year fixed
rates should be stacked in your favour. (Here is a recent rate simulation that I ran based on this key assumption.
It’s a little out of date but the gap between today’s fixed and
variable rates has widened since I wrote it, which tilts the playing
field even more in favour of the five-year variable.)
The Bottom Line:
The BoC’s decision to drop its tightening bias and offer a more
cautious outlook in its latest MPR opens up the possibility that its
next overnight rate move may actually be down, not up. While the variable rate is now sure to grow in
popularity, more than one of us have been arguing in its favour for some time.
David Larock is an independent mortgage planner and industry insider specializing in helping clients purchase, refinance or renew their mortgages. David's posts appear weekly on this blog (movesmartly.com) and on his own blog integratedmortgageplanners.com/blog). Email Dave