Bank of Canada Governor Stephen Poloz, fresh off the thorny question of inflation's longer-term trajectory, tipped his hand on the next tough issue he is preparing to tackle: Will interest rates ever return to their previous normal heights?
Mr. Poloz, in a CBC Radio interview the day after the central bank's quarterly monetary policy report (MPR), said the next MPR (in October) will delve into where the "new normal" for interest rates will be once all the post-Great-Recession dust settles. He believes that the normalized or "neutral" level for rates (i.e. the stable level for an economy operating at full capacity) will be lower than the previous historical norm, generally considered to be about 4 per cent for Canada.
Just how much lower? "We're researching this for our next monetary policy report," he said, declining to be lured into pegging a number to it.
On this front, Mr. Poloz finds himself again walking in the footsteps of his famed predecessor Mark Carney, who is now head of the Bank of England – and who, in typically bold and confident Mark Carney fashion, has named numbers for the "new normal." In a BBC radio interview three weeks ago, Mr. Carney said British rates should normalize around 2.5 per cent by 2017 – half the pre-crisis normal of 5 per cent. (The wisdom of talking about a specific number is debatable; it certainly creates some specific expectations in the market for what may prove a moving target over the next three years.)
"Things have changed," Mr. Carney said. "Households have a lot of debt. The government is consolidating its financial position. Europe is weak. The pound is strong. The financial system has been fundamentally changed – it has to carry a lot more capital, it has lot carry a lot more liquidity insurance and it will pass on those costs to borrowers.
"As a consequence of all those factors, in order to bring the economy back to full employment, in order to get inflation at target, the new normal is materially lower than the old normal," Mr. Carney concluded.
Canada faces some of those same factors, while others are less relevant in this country. But the common theme – not just for Canada and Britain, but across developed-world economies – is that growth potential is no longer what it once was. A lower ceiling on potential growth means an economy that reaches full capacity sooner, and interest rates at full capacity are lower.
While factors such as household debt deleveraging and government deficit fighting certainly contribute (less spending, more saving, lower demand for credit), the bottom line is demographics. The developed world is getting older, baby boomers are retiring, and so work-force growth is slowing – and that constrains economic capacity in a major way. In a speech in Halifax in March, Mr. Poloz said that as of next year "labour's contribution to the potential growth of the economy will be half what it was in 2007." Unless Canada can accelerate labour productivity growth (something that has proven very elusive) to make up for the labour force slowdown, this means less economic growth potential.
Should lower long-term interest rates be viewed as an open invitation for consumers to run up cheap debt? Probably not. The slower growth that leads to lower neutral rates will also mean slower growth in incomes. So while borrowing may stay cheap, consumers' capacity to service more debt will be contained, too.
It does imply a long-term headwind for savings, as a long-term lower rate environment will limit returns on investments. Pension funds will face challenges, although they have generally already lowered their long-term assumptions. But the bottom line is, we'll either have to save more or prepare for lower incomes in retirement.
These are factors the Bank of Canada will no doubt contemplate as it works through its analysis on the "new normal" for interest rates in the coming months. But central to the bank, and certainly something it will want to talk about when it raises this issue in the next MPR, is what a lower neutral rate implies for its monetary policy.
Interest rates are the bank's primary tool for managing the economy, and this will give the bank a narrower rate band in which to operate. The normal range of rates will be closer to zero than in the past, which will leave the bank less wiggle room to cut rates before it runs out of downside and is forced into unconventional policy. It certainly presents a brave new world for central bankers; discussions on the topic now could plant the seeds for monetary policy innovations in the future – and we just might need them.