Joe Oliver's concern about investors' excessive risk-taking is, ultimately, all about inflation. The world's fears of deflation spurred the extended easy monetary policies that have driven investors to risky assets – and complacency about inflation's burgeoning return poses a simmering threat to financial market stability.
The Canadian Finance Minister's comments Monday, suggesting that investors may be mispricing risk as they seek better returns in the extended low-interest-rate environment, reflects a growing sense in some quarters that markets are set up for a hard fall – and that day or reckoning may be closer than many investors realize, especially given the recent and unexpected surge in inflation in North America.
BCA Research recently noted that financial markets in the world's advanced economies have priced in very low inflation and negative real interest rates "until at least 2017." This has fuelled a combination of complacency and pursuit for yield that has elevated asset valuations "into risky territory."
The danger, it said, is that the markets have "overpriced the deflationary story." Investors look ill-prepared for a transition away from the disinflation theme; as a result, it warned, "an unanticipated development on the inflation side could cause a nasty market reaction."
The seeds of such a development may already be sprouting in the United States – where, frankly, it matters more than anywhere else, as upward pressure on official interest rates at the Federal Reserve would send tremors throughout global financial markets. U.S. inflation is now running at 2.1 per cent – and the price pressures are becoming more broadly based. National Bank Financial chief economist Stéfane Marion noted that in May, four key inflation components – food prices, owners' equivalent rent, medical care and hourly wages for non-supervisory workers – were all rising at an annual pace of more than 2 per cent at the same time, the first time that has happened since before the recession.
For now, the Fed remains unconcerned about inflation – and, for that matter, about the effects of extended low rates on asset values. But should these broader inflation pressures persist – and, in particular, should wage inflation pick up as U.S. unemployment continues its decline – the Fed may be forced to quell inflation by starting to raise rates sooner than the market is prepared for. Overvalued risk assets would, in that scenario, almost certainly face a rude return to earth.
While Canada's inflationary pressures still look considerably less developed than those in the United States, it is nevertheless seeing its own potentially problematic inflation buildup – and regardless, its markets wouldn't escape the impact of a U.S. inflation ramp-up. This is the kind of scenario that has Mr. Oliver, and others, nervous.
Yet it's unclear what Mr. Oliver would have us do. When he says, "I think it's something policy makers want to look at," what tools could policy makers have to convince investors to stop taking on risk in pursuit of yield? The most obvious, and meaningful, would be higher interest rates – which would raise yields on risk-free investments such as Canadian government bonds. Such a suggestion sticks a toe into the Bank of Canada's policy waters – where a finance minister's helpful advice is not always welcome.
Nevertheless, the Bank of Canada under Mark Carney's leadership was more than happy to tilt its policy bias toward higher rates sooner, as a means (at least in part) to cool what it saw as Canadian consumers' excessive appetite for debt. The current brain trust at the central bank, led by Stephen Poloz, has moved significantly away from this policy leaning.
And yet it could be argued that the threat of higher rates could have a similar value in reining in investors' appetite for risk. If central banks on both sides of the border were to become less dismissive about the emerging upside risk to their inflation outlook, it could have a constructive side effect of dousing markets, before their overheating becomes any more problematic.