Canada And The United States: Neighbors With Divergent Monetary Policies
According to Bank of Canada governor Stephen Poloz , a bank rate cut “remains on the table”. This statement comes at a time when U.S. Federal Reserve chairperson Janet Yellen speaks of the federal funds rate increasing “a few times a year “. It is often easy to just assume that whatever takes place in the United States, Canada will follow in lockstep. Yet, the two nations are pursuing quite divergent monetary policies. In the United States, growth and rising inflation expectations are pushing the Federal Reserve to take a more hawkish position on rates. But what is behind Canada’s reluctance to follow the U.S. path?
Inflation and Excess Capacity
When it comes to inflationary conditions, the two economies are quite different. Unlike the Federal Reserve, which has a dual mandate of price stability and full employment, the Bank of Canada has just one mandate: maintaining price stability. The Bank has set a target rate for the consumer price index in the range of 1 to 3 per cent. Moreover, the Bank considers that “the balance between (aggregate) demand and the economy’s production capacity is, over time, the primary determinant of inflation pressures in the economy” Recently, the Bank developed three new measures to obtain a more reliable gauge of the underlying trend of core inflation (See accompanying chart). All three measures have declined since mid-2016 to below 2 per cent. These measures reflect a considerable degree of excess capacity (the output gap) in the Canadian economy. The Bank places a lot of analytical stock in its measure of resource utilization, and so far, the output gap is quite wide.
Another measure of resource utilization is the unemployment rate. The United States saw its unemployment rate fall to less than 5 per cent in 2016 from over 8 per cent in 2012.The Canadian experience is much less successful; the current rate is 6.9 per cent compared to 7.6 per cent in 2012. Canadian progress in returning to full employment still seems a long way off.
An Unwelcome Rise in Canadian Bond Yields
Canadian bond yields backed up in line with the yields in the United States in the wake of the Trump election. U.S. investors believed that the new government would introduce many pro-growth measures leading to a higher inflation rate. Inflation expectations in the United States, after falling for more than a year, did an about face and now have risen considerably. However, given the Canadian measures of low inflation and excess capacity, the increase in yields is unwelcome. The yield on the 5 year bond, the one often used to set mortgage rates, has jumped by 50 basis points since the U.S. elections. The importation of higher bond yields, at a time when the Canadian economy continues to display considerable slack, only makes it harder for the economy to expand.
U.S. Fiscal and Trade Policies
Above all, there stands the heightened uncertainty regarding the economic policies of the incoming U.S. administration. On the fiscal side, the Bank is concerned that major corporate tax cuts in the United States will affect decisions of companies engaged in cross border trade. At this early stage, it is not possible to determine just how future investment will be affected. Yet, the risk assessment plays a big part in the Bank’s policy deliberations. As for trade policy, the Trump administration has made it clear that a renegotiation of NAFTA is very high on its priority list.
In sum, the Bank has taken a prudent stance on rate policy. Domestic conditions warrant that the bank rate remains steady. Any further increase in excess capacity would justify a rate cut. Where the Canadian economy is most vulnerable is from future shocks originating from drastic changes to NAFTA and to U.S. tax policies that directly impact cross-border trade. We will know soon enough whether a bank rate cut is required.