Some thoughts on the MPR

The market reaction to the release of the MPR was all about the unconventional, but I'll start with the conventional.

The Bank reduced its forecasts for growth prospects, as expected, relative to the January MPR Update, to -3.0% expected this year, +2.5% next year, and +4.7% in 2011. It attributes the downgrades primarily to the significant unforeseen foreign weakness propagating through trade, financial and confidence channels (adverse feedback loop), and to delays in implementation of policies to stabilize the financial system (particularly in the U.S.).

But the Bank remains relatively more upbeat than some other forecasters (see previous post), and continues to project a more robust recovery in Canada than in other countries. So, though the recovery will be delayed and more gradual than previously anticipated due to the unanticipated intensification and synchronicity of the global recession (particularly acute in Europe and Japan, with knock-on effects on global trade), the Bank continues to expect above-potential growth in Canada in 2010 (albeit with a lower estimate of potential output growth).

The Bank has a long list of factors that it views as supportive of this prediction, including the scale of its own monetary policy response, the relatively well-functioning Canadian financial system, the past C$ depreciation, fiscal stimulus, a gradual rebound in external demand, the strength of balance sheets in Canada (household, business and bank), and the end of residential housing stock adjustments both in the U.S. and here. More generally, it believes that bold policy actions globally, an end this year to the U.S. housing drag, and a relatively robust China will all be positive factors for the global economy.

However, there are obviously numerous challenges also. Though Canadian households have entered this downturn with balance sheets that are not as stretched as elsewhere, they have reacted with a similar increase in their desired savings rates. And, though Canadian households have generally had lower rates passed on to them, businesses are facing difficult financing conditions. Further, U.S. weakness has mostly been in sectors that have a large impact on Canadian exports (housing and autos). Also, there has been significant unwanted inventory accumulation. And, due to the steep drop in the terms of trade, there has been a similar sharp drop in real gross domestic income (which is forecast to decline 6.4% this year). Investment in housing is expected to fall all this year and business fixed investment is expected to drop sharply. And the output gap, which is estimated to be about 3% currently, is expected to widen to 4.5%.

Perhaps the most notable change in the Bank's report is that it has dropped its estimate of the economy's potential output (i.e. the pace of output growth that would be non-inflationary). Previously, it had viewed potential as 2.4% (for this year, and 2.5% going forward). Because of the structural change going on in the economy (especially in autos and forest products), it now views potential output as just 1.2% for this year, 1.5% next year, and 1.9% in 2010. Clearly, lower potential output estimates, if accurate, will make it easier to close the output gap and thus start get inflation back towards the 2% target (not anticipated for 10 quarters, in Q3/'11).

The Bank notes that if the economy deteriorates any further than currently expected, because its overnight rate is currently at its effective lower bound for conventional monetary policy, it would need to react with unconventional policy. And, given the degree of uncertainty related to such new policies, it would therefore need to use prudence with these initiatives (i.e. it will be cautious about how much it uses these programs, if at all). Therefore, it says that implies that inflation risks remain tilted, though slightly, to the downside.

All this will likely be very sensitive to its assumptions on the stabilization of the global financial system, given that it continues to maintain that such stabilization is a precondition for recovery. And the Bank seems to be unimpressed so far with the pace of progress in this regard. The Bank did not really outline its expectations for further credit losses in the global financial system, nor for the pace of resolution of impaired legacy assets, so its hard to evaluate this element. Another risk is the ever-present one of the potential destabilizing resolution of global imbalances. (The Bank did not comment on the fact that it seems that most government stimulus that has been enacted so far seems to aggravate existing imbalances, i.e. that American stimulus is somewhat focused on reviving U.S. consumption, while Chinese stimulus is somewhat focused on the investment and export sectors.) The Bank's forecasts would also be sensitive to its assumptions on the currency (C$ = US$0.80), oil (from $50 now to $60 at year-end, to $70 in 2011, based on futures) and non-energy commodity prices (increasing progressively with global economy).


Now, turning to the unconventional. The Bank views its commitment to keep its overnight rate at its current low level for over a year (and future conditional statements about the future path of policy rates) as its first main instrument of unconventional policy. It hopes that because long-term rates represent averages of current and expected future short-term rates (plus term premiums), that it can influence the government yield curve lower, and in turn support prices of other financial assets, and, in turn, aggregate demand.

That we already knew on Tuesday. And, unfortunately, there's really nothing in the MPR about quantitative easing (QE) (which would involve purchasing government or private assets, paid for by expanding the money supply), or credit easing (CE) (purchases of private sector assets, but sterilized, so the monetary base doesn't change) that's new or noteworthy either. The only new info is (1) that if it does purchase private assets, it will be restricted to those exhibiting a clear market failure, and (2) is the publication of the principles it will use to guide its actions. Newsflash #1, its focus is on its inflation target. 2) anything it does should be concentrated where it will have impact (perhaps purchasing 5yr GoCs would have more impact than buying 2s, particularly given that the impact the Bank is ultimately worried about is on private sector interest rates). Its principles of (3) neutrality (limit potential distortions) and of (4) prudence (don't unduly risk the Bank's balance sheet), seem to indicate a preference for QE over CE.

Other asset implications? Given how little detail is provided on this new monetary policy framework, its really hard to know. Probably there will be just as many guesses out there in the market today as to what they might do as there were yesterday (GoCs? provies? CMBs? corporate bonds? CP? ABCP? ABS?).

Ultimately, it appears that the Bank's outlook on the economy and inflation, and its conditional commitment to low rates, should be favourable for lower rates along the government curve. And, if anything, it appears that the Bank remains relatively optimistic that global financial instabilities will be resolved soon enough to foster the growth its looking for. Not that it can do anything about it, but that leaves the Bank relying on Timothy Geithner too much for my liking.

Really, what it comes down to is, will the Bank's forecasts be more accurate than those of the IMF and OECD, or not. If so, then no QE or CE. But, if not, it will take longer to get inflation back on target, with potentially a larger miss in the meantime, implying an announement in June (or more likely at another future fixed action date) about what particular QE or CE measure it decides it needs to employ.

But, in any case, it seems clear that the Bank feels there's a greater burden of proof that there's a need in order for it to go down that road. It too may be looking at 2nd derivatives and green shoots and hoping to not need to invoke too many extraordinary measures.