The Bank of Canada's move to stand pat on interest rates was not surprising, as the Bank's most recent monetary policy report pegs inflation at just under 2 per cent for the next three years, in line with its mandate. Presently, core inflation is significantly below 2 per cent, but monetary policy works with a lag, so future inflation – not current – is the Bank's primary concern. Given this forecast, the Bank had little choice other than to leave rates unchanged.
However, expectations of 2 per cent inflation are hard to reconcile with short-term bond rates, which are significantly below 2 per cent. The two year bond rate is currently at 1.06 per cent, while the three year bond rate is slightly higher at 1.13. These rates have been declining in recent months (though are up from summer lows); this is also difficult to reconcile with expectations of inflation rising to 2 per cent. If the Bank of Canada is correct, then anyone buying one of these bonds will receive negative real returns, as the interest payments will not even cover the rate of inflation. There are three possible expectations for this disconnect between inflation expectations and bond yields – and all of them are cause for concern.
First, it is possible that the Bank is overestimating future inflation, so realized real returns will be higher than they currently appear. This is certainly plausible, as the BoC has been overestimating inflationary pressures over the past few months. If this is case, then the economy will also grow slower than the Bank of Canada has forecasted and the Bank should be lowering rates rather than standing pat.
Second, bond markets may be underestimating future inflation, which is causing bonds to be mispriced. This is certainly possible, as a number of investors have warned that there is a bubble forming in bond markets that is ready to pop, which would send bond prices crashing (and bond yields soaring). This, in my view, is the least likely outcome, but should not be ignored. A bond market crash would cause a significant devaluation in many portfolios, causing suddenly poorer consumers to cut back on their spending.
Finally, it is possible that both bond markets and the Bank of Canada are forecasting inflation accurately, and bond investors are, in fact, willing to accept significantly negative real returns. There are a number of factors which can cause negative real returns, so the story gets a little complicated.
Lower real interest rates are associated with loose monetary policy, as more money is being made available for borrowing. However, to push real interest rates to near negative 1 per cent, markets would have to be absolutely flooded with money, overwhelming the short-run ability for firms to borrow it all. It could also be caused by a flight to safety, as international investors buy up financial assets in safe havens such as Canada, which causes bond prices to rise (and their yields to fall).
Both overly loose monetary policy and massive capital inflows to Canada as a "flight to safety" seem plausible but are likely incorrect. If either of these were true, we would expect to see a significant rise in the S&P/TSX, as some of this printed money or foreign capital found its way to the stock market. This has not happened, in fact the index has been relatively flat over the last six months. Given these market indicators, a negative real interest rate most likely indicates a lack of demand by consumers and businesses to invest. This poses a significant problem, as robust investment is required for both short-term economic growth and long-term productivity gains.
I suspect that the Bank of Canada's model is overly bullish and inflation will come in under expectations, as the model may not have fully accounted for the U.S. fiscal cliff and the ongoing difficulties of the euro zone. Even so, realized real interest rates are still likely to be negative, a sign investors still have a great deal of uncertainty about short-to-medium term economic growth. I will not feel confident that the Bank of Canada is making the correct call on monetary policy until two– and three-year bond yields begin to recover.