Bank of Canada rate cut necessary as pre-emptive strike
Originally published in the Financial Times, on January 27, 2015.
In this guest post, Alex Bellefleur, global macro strategist at Pavilion Global Markets, writes that the Bank of Canada was prudent to loosen monetary policy in response to the decline in oil prices.
Last week the Bank of Canada (BOC) surprised markets by cutting interest rates 25 basis points, leaving them at 0.75%. While some argue this move was unnecessary, we are of the view that the cut is needed as a pre-emptive manoeuvre to counter private sector deleveraging.
Deleveraging processes tend to begin with asset price or income shocks (see: U.S., Spain, Ireland). Canada is currently undergoing an important income shock thanks to the collapse in the oil price, which will probably give way to an asset price shock. If history is any guide, this scenario will trigger a deleveraging process, which will represent a significant structural change for the Canadian economy.
The economy has been going through a quasi-interrupted leverage supercycle since the mid-1990s, aided and fueled by the rise in energy prices over the latter part of this period.
As we have seen in the U.S. and Europe, an economy can become mired in a liquidity trap when households focus almost exclusively on minimizing debt burdens. Initially, the central bank responds by cutting rates aggressively in order to ease the pain on the deleveraging household sector. This seems to be what the BOC is doing at the moment, pre-emptively, as it would be difficult for the BOC to argue that Canada is somehow different and completely immune to deleveraging pressures following an income/asset price shock.
The other important element in a deleveraging/liquidity trap is fiscal policy, which no one in Canada seems to be talking about at the moment. When interest rates are hovering around the zero lower bound and households are deleveraging, fiscal policy becomes paramount and the economy tends to respond better to fiscal stimulus.
When U.S. real government spending was contracting sharply around 2010-11 amid U.S. private sector deleveraging, the economy was underperforming expectations and Treasuries were rallying. The same movie played out in Europe as fiscal austerity was applied through a general environment of private sector deleveraging, amplifying the recession.
It is interesting to note that growth in Canadian real government spending is currently at its slowest since the mid-1990s period of fiscal consolidation:
Canadian provinces, which are responsible for health care and education spending, are all dealing with budget pressures. The federal government has also vowed to attain a balanced budget. If fiscal austerity hurt in the U.S. and Europe, it is difficult to see how Canada could remain immune. This is another reason why the rate cut looks appropriate at this juncture.
Let’s say the BOC didn’t cut rates on the basis that it was worried about further inflating the housing bubble. This would amount to what Paul Krugman dubbed “sadomonetarism”, which was applied in Sweden (another small, open economy closely tied to a much bigger one) in 2010-11. The results were disastrous and ended up sending Sweden into outright deflation. The BOC is no doubt aware of the Swedish lesson and wants to prevent this type of situation from happening in Canada.
The rate cut has also been questioned on the basis that the oil price drop would help the country’s manufacturing sector, which would pick up the slack from the resource industry.
One might be tempted to think of the Canadian oil/currency drop as a reallocation of wealth within the country from West to East, or from resource extraction to manufacturing. The problem with that thinking is that manufacturing orders and sales have been weak in recent months, suggesting that it is more difficult than previously thought for Canadian manufacturers to hitch their wagons to a growing U.S. economy.
This is probably due to a competitiveness problem. Canadian productivity growth has lagged the U.S. for years and the country’s export market share has been decimated over the past decade. The link between a resurgent U.S. economy and the Canadian manufacturing sector appears tenuous in the current cycle:
Another indication of the competitiveness problem is Canada’s current account deficit ex-energy, which remains around 6% of GDP despite the currency depreciation of the past few years:
In this context, rate cuts to weaken the currency and re-establish some competitiveness make sense.
The lessons of the past few years on deleveraging, premature rate hikes on macro-prudential grounds and loss of competitiveness are too important for the BOC to ignore. This is why the move to cut rates was justified.