A Very Defensive Bank of Canada Governor Takes Issue with His Critics

Several critics, including this author[1], have taken issue with the Bank of Canada signaling that the bank rate should continue to rise to 3 percent from its current level of 1.75 percent.  The Governor makes the argument that economic growth is ‘solid’, thus allowing for further tightening. Critics, on the other hand, dismiss the Bank’s rather ‘rosy’ outlook for Canada[2]. They point to the IMF’s downgrading of global growth and trade; the slowdown in China; the slump in financial markets in North America; and, in Canada where both employment and wages are stagnating. The Governor answers his critics by trying to reconcile the Bank’s latest outlook to recent developments in the financial markets.

In a recent speech,[3]  Governor Poloz offers a brief lesson on how the financial markets are operating in response to recent policy moves by central banks to tighten lending conditions. He argues the Bank’s views about the risks facing the global economy are consistent with risks experienced in the financial markets.  In a nutshell, the Governor maintains that risks facing investors are balanced and as such the Bank could adopt a more hawkish position regarding interest rates.

Every central banker has long wanted to see higher long-term rates and an upward sloping yield curve as a sign that the economy is healthy and growing. However, the actions of the central banks are making more difficult to maintain a healthy economy. The Federal Reserve is not only raising rates but is shrinking its balance sheet and thus soaking up liquidity worldwide. The withdrawal of liquidity is putting a great deal of stress on markets both domestically and internationally. As mortgage-backed -securities are cashed in by the Fed, the US mortgage industry is looking at higher rates and considerable pressure on housing. Internationally, the emerging markets must grapple with a stronger US dollar and capital outflows in response to US interest rate hikes.

More to the point, it is not at all a foregone conclusion that rising long-term rates are a product of ‘solid’ economic performance. The US government has gone deeply into the red, issuing ever greater amounts of debt that needs to priced higher in order to attract investors at home and abroad. It is not possible to separate the widening US government deficit from higher long-term rates.  The recent surge in long-term rates is not supported by any significant increase in inflation. It is inflationary expectations that dictate long-term rates.

The Governor then went on to discuss recent downturns in the equity markets claiming that “the era of extraordinary central bank liquidity helped make stock markets more one-sided, naturally suppressing their volatility. Now, this liquidity is becoming more expensive, so it is only natural to expect more volatility in stock prices as this support is removed “.

In contrast, many analysts argue the reason that equity markets are in retreat is that earnings are growing slowly and the outlook for future profits is dimming.  Corporate profit growth is not so ‘solid’.  Withdrawing liquidity will only exuberate the challenge that corporations face to maintain earnings, finance debt at higher interest rates and contend with trade protectionist policies worldwide.

The Governor makes a valiant effort to minimize the risks affecting the Canadian outlook. In his view, the adjustments in the financial markets are just a normal response to a shift in monetary policy. On the contrary, market participants do not see these risks as evenly balanced, but rather as a major headwind and question the need for future monetary tightening to the degree advocated by the Governor.

[1] The Bank Of Canada Is Way Too Optimistic In Its Outlook ; The Bank Of Canada Will Drop Anchor At A 3% Bank Rate;

[2] David Rosenberg: Things aren't nearly as rosy as the Bank of Canada believes;

[3] Speech to Canada-UK Chamber of Commerce, Nov. 5,2018