Steve Ambler is the David Dodge Chair in Monetary Policy at the C.D. Howe Institute and a professor of economics at the University of Quebec. Jeremy Kronick is associate director, research, at the C.D. Howe Institute.
The Bank of Canada announced last Wednesday that it’s continuing to hold its overnight target rate constant at 1.75 per cent. No surprise there. What is interesting, however, is a major turn of events in the economic outlook.
The global economy appears to have gone from being a drag on Canadian growth to a strength, whereas the domestic Canadian economy, once a growth driver, appears to be slowing down. The Bank of Canada still faces a balancing act – although it at least has the tools to fight domestic weakness.
The target rate in Canada has remained constant since December, 2018. Elsewhere, several major central banks lowered their policy rates in response to earlier signs of weakness in the world economy and major uncertainties.
Among the countries whose central banks cut rates in 2019 were Australia, Denmark, India, South Korea, Mexico and the United States. The European Central Bank, which has had a policy rate of zero since 2016, lowered the interest rate it pays on reserves to minus 50 basis points in September, and provided stimulus in the form of quantitative easing.
Last fall, the sentiment was that the Canadian central bank’s decision to leave its policy rate unchanged, despite falling rates at central banks around the world, had to do with a robust domestic economy in the face of weakening economic conditions abroad. However, the feeling was the bank would not wait much longer, and a rate cut was just around the corner. The corner continues to be just out of view, although for the opposite reason: signs of weakness in Canada combined with a relative strengthening in the rest of the world.
Let’s first look at the situation abroad. The U.S. and China seem, provisionally at least, to have worked out their differences. Canadian agricultural exports to China may suffer as a result, but Canadian companies linked to China and the U.S. in international supply chains should benefit. The new North American free-trade pact, the U.S.-Mexico-Canada Agreement, is on the verge of being ratified by all three parties.
The latest world economic outlook, published by the International Monetary Fund in October, projects that world economic growth will pick up to 3.4 per cent in 2020 from 3 per cent in 2019 (the lowest growth rate since the financial crisis in 2009). This should relieve the downward pressure on central bank policy rates in the rest of the world.
Looking domestically, we need to distinguish between some signs of weakness in the real economy, on the one hand, and what the labour market means for pressure on inflation, on the other hand.
Start with the real economy. Growth in the fourth quarter of 2019 was weak, led by a fall in exports, and a slowdown in business investment, likely a lagged effect of the global uncertainty that put a dent in global growth.
The Bank of Canada’s latest monetary policy report was also released last Wednesday. The bank has lowered its forecast for Canadian GDP growth in 2020 to 1.6 per cent from 1.7 per cent (in the October MPR).
Weak business investment has directly translated into weak growth in labour productivity, one of the main determinants of the rate of increase in capacity output. The bank’s latest measures of the output gap, the difference between actual output and the maximum potential output, indicate a small amount of economic slack.
In its announcement, the bank said it expected the output gap to widen slightly in the short run. However, inflation remains around the 2-per-cent target, which leads us directly to the situation in the labour market.
Here, the story is muddled. On the one hand, total employment and wage growth have been quite impressive, meaning the economy is operating with little slack, which will put upward pressure on inflation. Canada’s unemployment rate (5.6 per cent in December) is close to its historic low of 5.4 per cent in May, 2019. Wage growth for permanent employees was 3.8 per cent (annualized) in December, down from 4.4 per cent in the previous month.
However, employment and total hours grew slowly in 2019, with total hours worked in December up just 0.3 per cent from December, 2018. If this trend persists, perhaps the labour market is not as robust as other measures suggest, which will put downward pressure on inflation.
What does this all mean for a forward-looking central bank? It means setting monetary policy is hard. When the U.S. and China engage in a trade war, that is out of the bank’s hands. Fortunately, not so a weak labour market.
Data in the present tell a mixed story, and if forecasting is difficult when all data point in one direction, it is that much harder when the data point in different directions. The silver lining, at least, is that the Bank of Canada has the tools to fight weakness at home.