David Letterman Visits the Central Banks
Most of the financial world focused on the ECB’s long-awaited decision to embark on full-scale QE this week, and they miraculously managed to exceed expectations. But that was far from the only surprise that central bankers unleashed in 2015. Following last week’s stunner from the Swiss National Bank to let the franc loose, the past week brought a rapid-fire run of interest rate cuts from Denmark, India, Turkey and, of course, Canada. Suffice it to say the BoC’s rate cut caught almost everyone by surprise—we thought we had been brave last week, when we suggested that the Bank would not raise rates in 2015, and that the Canadian dollar could weaken as low as 80 cents (US) later this year. The Bank did us one better on the rate front, promptly sending the currency close to our full-year target within a matter of days. Now forgive me dear reader for lapsing into irony and sarcasm, the lowest form of humour, but the shock of the rate cut left us scrambling for explanations for the decision. Here are my Top 10 (admittedly ironic) reasons:
10. Household debt levels weren’t high enough already. After four years of scolding Canadians about taking on too much debt, the Bank has pretty much said “oh, never mind, we’ve got your back”, despite the fact that the debt/income ratio is at an all-time high of 163%.
9. Home prices weren’t hot enough. Even the prospect of lower rates, or at least the confirmation that rates are not going up anytime soon, could further fuel a still-hot housing market. While Alberta will soon be limping, prices in a few other regions are already plenty frothy.
8. The C$ wasn’t falling fast enough. Even before the rate cut, the Canadian dollar had dropped 12% since the start of 2014. With the further 3% plunge in the currency since the Bank’s rate cut, it is now down at its second fastest clip ever over such a stretch outside of the financial crisis.
7. Record low long-term bond yields weren’t low enough. Again, even before the rate cut, Canadian 10-year yields had already punched below 1.5%, providing a market-led windfall for borrowers in any event.
6. The economic and financial backdrop wasn’t uncertain, exciting and volatile enough. Most believed that a stable, predictable Bank of Canada policy was one anchor we could count on. Not so. With Canadian consumer sentiment already buffeted by all the uncertainty surrounding falling oil, the C$ drop and Target’s shocking retreat, the Bank decided to amp things up another notch.
5. Canadians were saving too much. After finally managing to nudge above 5% of income in 2012 and 2013, the savings rate fell back below 4% in Q3 of last year. Apparently, the playing field needs to be tilted even further in favour of borrowers, at least in the Bank’s eye.
4. Car sales weren’t strong enough. Besides housing, the other big-ticket item that finds heavy duty support from low-low interest rates would be auto sales. And, they have racked up record sales in each of the past two years, and were bound to find even further support from plunging gasoline prices. The Bank decided to throw another log on the inferno.
3. Pension plans were getting too comfy. After finally getting back into fully funded status by the end of 2013, the surprise plunge in bond yields pushed many plans back into a deficit last year. By essentially ratifying the latest plunge in yields with its rate cut, the Bank has just made life that much more difficult for pension plans.
2. The BoC wanted to share in the fun of getting flat-footed in its forecasts. True, there were a few voices calling for the possibility of a rate cut, perhaps later this year. But no one had called for a move in January, and the Bank gave zero hint that a rate cut was a possibility in its prior statement in early December.
1. The Leafs needed a lift. Hey, when you only have a hammer, every problem (no matter how unsolvable) looks like a nail.
Somewhat more seriously, the Bank argued that the move was an “insurance policy” to protect the economy against the ill effects of plunging oil prices. But, insurance policies are not free lunches; they have a cost. Many argued in the immediate aftermath that the Bank made the correct decision and/or there was nothing to lose from the move. I would respectfully disagree. Besides the obvious risks to financial stability alluded to above, arguably the biggest risk is that the move may well backfire in terms of supporting demand. A common remark I received in the wake of the rate cut was “what does the Bank know that we don’t know about the economy?” Far from helping growth, the rate move could actually increase consumer and employer anxiety and uncertainty. More fundamentally, the economy’s shape is arguably already heavily skewed by the persistence of negative real interest rates, and the cut threatens to make the skew grotesque. The one saving grace was that the TSX responded big-time to the move, and is now in positive terrain on a year-to-date basis. We have not changed our forecast on GDP growth as a result of the rate cut, holding at 2.1% for the year (which, coincidentally, is where the Bank trimmed its view to this week).
Looking ahead, we suspect that the Bank isn’t done yet. Even with core inflation stubbornly rising to 2.2% last month, and even with consumer spending holding up nicely, the Bank is concerned about the hit from weaker capital spending and the potential follow-through to the job market. After two declines in a row, next month’s employment report takes on added import (due February 6). The Bank said if current oil prices persist (“around $50”), this would shave their real GDP growth forecast in H1 from a 1.5% average to 1¼%, and widen the output gap, and push the closing of the gap into 2017. Thus, the case for a second insurance move looks supported by oil prices merely moving sideways, let alone falling further. (The Bank’s take on lower oil prices shifted in a mere 8 days from “are likely, on the whole, to be bad for Canada” to “unambiguously negative”.) We are pencilling-in another rate cut next meeting (March 4th). This could be delayed or even cancelled should, during the weeks ahead, the loonie weaken significantly more, oil prices improve materially (closer to $60), or the U.S. economy markedly revs up with signs this is rippling across the border. Absent those factors, we look for the Canadian dollar to weaken further, and we have chopped our mid-year forecast low to 77 cents. Here’s hoping that this revised call is not also hit within the next week.
Douglas J. Porter, CFA | Chief Economist | Managing Director, Economic Research
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