Some commentators view the bond market’s current preoccupation with inflation as posing a serious problem for the Bank of Canada. It needn’t be. Inflation is the one problem that Canada’s central bank is pretty much built to handle.
The bank just needs to stick to what it has been saying all along: that it would exit quantitative easing – its purchases of government bonds – once the economic recovery “is well under way.” If “well under way” has moved closer, it may now be time for the bank to start laying the groundwork for a gradual and well-signalled phase-down of QE.
Bond yields have climbed rapidly since the start of the year, and rising inflation expectations are generally cited as the reason. The surge can be traced to the arrival of COVID-19 vaccines both in Canada and abroad, which have dramatically accelerated both the timeline and the certainty for a fading of the pandemic and an economic return to normal. That implies inflationary pressures will start to build sooner than the markets, and central banks, had previously expected.
As Bank of Canada Governor Tiff Macklem acknowledged in a news conference last week, bond traders had been worried about the downside risks for inflation and the economy earlier in the pandemic, but they have adjusted their thinking, as resilient economic indicators, together with the vaccine rollout and the continued benefits of fiscal and monetary stimulus, have brightened the outlook.
What he didn’t say is that it remains for the Bank of Canada to make its own adjustment. It doesn’t help that the bank only formally revises its projections for GDP growth and inflation on a quarterly basis, with its next update scheduled for the third week of April. But it’s fair to say that central banks around the world have been much slower to embrace this building inflation story than bond traders have been.
The markets now see a risk that continued exceptionally loose central bank monetary policy will add fuel to a building inflation fire. Couple that with plans from both Ottawa and Washington for massive new fiscal stimulus programs this year, and you have the makings of inflation getting out of hand. This is the argument that is increasingly driving the rise in North American bond yields.
With the average yield on five- to 10-year Government of Canada bonds having doubled in the past three months (to about 1.2 per cent, according to the Bank of Canada’s tracking), the market forces are increasingly testing the central bank’s hand in its QE program, under which it has been purchasing $4-billion a week of government bonds with the goal of dampening interest rates. It does appear to present a conundrum for the central bank.
At this point, it’s important to remember that the one thing the Bank of Canada worries about above all else – and the one and only thing its monetary policy is expressly directed at controlling – is inflation.
The bank knows its economic estimates for the start of the year are too low. It knows the economy is on a higher trajectory than it anticipated. It knows massive additional fiscal stimulus programs are on the table on both sides of the border.
Its playbook in an overstimulated, inflationary economy – one that is being driven by a fast-improving economic outlook – is crystal clear. It must begin to unwind its ultrastimulative monetary policy. It must dial down the contributions to the economic acceleration over which it has control.
This doesn’t have to happen immediately. As Mr. Macklem has rightly pointed out, the economy remains far below its full capacity, which implies sustainable inflation is not on the immediate horizon. The bank has pledged to keep its key interest rate at its 0.25-per-cent floor until the economy returns to full capacity and sustained inflation at the bank’s 2-per-cent target, and that still looks a long way off – although not as far as the bank has been projecting.
But the economic and market signals justify the bank changing its message, to set the stage to gradually wind down the QE program. That could start as early as next week, when it releases its next interest-rate decision (Wednesday), followed by an economic update speech by deputy governor Lawrence Schembri (Thursday). It could use these as an opportunity to communicate that the economic outlook is improving and the time frame for the recovery is accelerating.
That would set the stage for a reduction of the QE program at the next rate announcement in April, when the bank will have its full quarterly Monetary Policy Report to provide formal outlook revisions and spell out its policy thinking. The bank could scale it purchases back to, say, $3-billion a week from the current $4-billion – maintaining its commitment to continue QE until the recovery is “well under way,” while paying due heed to the evolving inflation outlook.
Some critics will say to do so would effectively concede that rates are destined to move higher and undermine the bank’s commitment to keeping them low. But while it was arguably the bank’s job to counteract market pressures in times when the market was under stress, that is no longer the case. Its clear policy priority – to lean against inflationary pressures – argues to prepare to retreat from its QE program keep its economic stimulus in check and leave the market to make up its own mind.
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