The Bank Of Canada Digs In For A Long, Slow Recovery

The Bank of Canada (BoC) is now signaling that the nation is going to endure a very long and uncertain recovery from the coronavirus shock. In addressing the future for monetary policy and the Canadian economy overall, the recently-installed new Governor, Tim Macklim, “expect(s) to see a pretty good bounce-back through the third quarter; but then we see a longer, slower, bumpier recuperation phase.” He assured Canadians that the Bank will do its utmost to support the recovery process. He offered encouragement, tempered with a strong dose of reality, to wit:

Forward Guidance. His predecessor, Stephen Poloz, always skirted the issue of what would likely be the path of interest rates, in the hope that rates would return to their long-term equilibrium levels. There was always the reference for the need to assess incoming data, leaving open the option to switch gears should the data warrant. However, the Bank has adopted forward guidance as a major policy tool. In this instance, the “policy interest rate would be at the effective lower bound for at least two years”.  Generally, central bankers hold their cards close to their chests and investors are constantly second-guessing rate changes. In this way, the bankers could not be accused of directly influencing financial markets. Put differently, investors could not game the system.

Now the BoC wants to provide as much clarity as possible in support of the recovery process. Implicitly, the BoC is saying that rates will not go up, but will they go down? However, it is entirely plausible that the economy will not recover sufficiently and that the bank rate might have to be cut further to zero or perhaps below zero, despite the protestations by the BoC that it is not contemplating a negative policy rate. Nonetheless, the policy rate will continue at its current level until the economic slack is absorbed and the inflation rate hits the 2% target.

Inflation Outlook. The BoC accepts that there will be considerable slack in the economy over the next couple of years. Aggregate demand will continue to fall short of overall supply and disinflation will likely prevail. Thus, Macklim is more worried about deflation than inflation, and this allows the BoC to give such clear forward guidance that interest rates are going to be very low for a long time. The goal of sustainable 2% inflation will become more elusive. Most likely, the two-year forward guidance will be extended.

Yield Curve Control. YCC is widely used in Japan whereby the Bank of Japan is a participant in the bond market in order to meet certain interest rate targets for government bonds. The BoC is a relative newcomer to quantitative easing and so far, its balance sheet is just starting to expand. But it's still relatively modest by international comparisons. YCC is not on the BoC front burner at the moment. 

Potential to Grow. All recessions leave their scars on a nation’s growth rate and this deep, indeterminate recession, will have profound effects. We are already seeing signs of major upheavals in the labor market with tens of thousands of workers leaving the labor force because they cannot find suitable employment. The expected surge in company failures and the drop off in immigration will result in the reduction in our capability to provide goods and services. This will, in turn, affect overall demand and national output. Moreover, business capital investment has ground, virtually, to a halt and this means that we will not be adding to the nation’s capital stock to enhance productivity. How much damage is there to the economy’s productive capacity is not at clear while we are in the midst of the pandemic.

When asked about risks to the bank’s policy outlook, the Governor stated “the biggest risk is that as we reopen the economy, we do get a widespread second wave and we need another second lockdown. That would certainly be a big setback to the recovery. It would put us well below our central scenario and clearly that would be a case where we would definitely need more monetary stimulus.” Thus, the path of the public health crisis will dictate the bank policy above all else.