Royce Mendes takes a second look at the Bank of Canada’s commitment to keep rates pinned down and finds an interesting twist that could prove significant for investors as the recovery gains steam. He also previews next week’s Federal Reserve meeting and the GDP data set to be released in both the US and Canada.
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Royce Mendes: Good morning, everyone, and welcome to the 16th episode of Curve Your Enthusiasm. I'm your host. Royce Mendes, Executive Director and Senior Economist at CIBC Capital Markets. I'm doing the show solo this week as my regular co-host, Ian Pollick, Global Head of Fixed Strategy, is off on his two weaker. I want to kick things off by circling back to the Bank of Canada. I've been assessing the bank's commitment to keep rates at zero until inflation reaches target and realizing that there might be more to it than just simply guiding interest rate expectations. Upon further reflection, I actually think it was the strongest vow to generate an inflation overshoot that we've seen from any developed market central bank. Hear me out. Late in the last cycle, both the Federal Reserve and the Bank of Canada stated that they'd be comfortable allowing inflation to rise above their respective targets. Inflation in both countries had generally undershot in the years following the 2008-2009 financial crisis, and policymakers were worried about expectations becoming de-anchored. The problem was that both central banks initiated rate hiking cycles well before inflation was at target and actually tightened policy so much that they muted the inflationary tendencies, which would have allowed the overshoot they claimed they'd welcome. As a result, I think they lost some credibility and that's hurting them now. You know the old saying, fool me once. But Governor Macklem's pledge to leave rates alone until inflation is actually at 2% appears to me to be an almost ironclad assurance that underlying inflation will rise above the 2% target at some point in this cycle. That's because given the lags in monetary policy, waiting to hike rates until the inflation rate is already at 2% will almost certainly lead to an overshoot. In the days after the announcement, Canadian breakeven inflation rates only drifted higher. The lack of a sharp move in response to the commitment, however, shouldn't lead anyone to believe the policy doesn't have teeth. The pledge to keep rates low doesn't do anything really to get us to the 2% inflation target any faster. It only makes the commitment than when we get there, the bank won't halt the momentum. In the near-term, inflation expectations and compensation will still be driven by the path of the virus. But if some of the downside risks to the economy dissipate, Macklem's pledge could have more of an effect on breakeven rates by altering the skew in risks. All right, let's turn our attention to the week ahead in both the US and Canada. The Federal Reserve is meeting on Tuesday and Wednesday. While there's likely to be more stimulus introduced at some point, I don't think it'll be after next week's meeting. Under consideration are likely a conditional commitment, maybe one akin to that introduced by the Bank of Canada to wait longer in this cycle to raise rates to ensure that inflation is pulled up to target, as well as potential changes to the composition of the Fed's asset purchases. There are also, of course, in the midst of their strategy review, which could include a higher inflation target. Again, though, with the situation evolving so quickly, US central bankers will likely want to get a better sense of the outlook before making any changes. On that note, we'll get a reading on US Q2 GDP after the Fed meetings conclude next week. The aggressive reopening of the US economy will likely leave GDP outperforming the most pessimistic forecasts in the consensus right now. The problem is that same aggressive reopening has led to enough of a surge in virus cases that we've had to slash in half our growth expectations for the third quarter. Some early indications already suggest that the US economy shed millions of jobs again in July. The less inspiring outlook for the US, of course, has implications for Canada in the second half of 2020. But for next week, we'll just be getting a reading on the state of the economy in May. Statistics Canada already released an advance estimate of GDP growth for the month in the range of 3%. And I don't want to second guess their number too much because they've had a decent track record with these advanced estimates. But I see room for at least a bit of upside risk here given what we've seen in some of the other numbers for May. Maybe more interestingly, Statistics Canada will probably again provide us with a preview for the following month, which in this case is June and maybe even for the whole second quarter. We're expecting a strong showing for the economy in June, with Quebec and Ontario easing a number of restrictions outside of major cities early in the month and inside of cities like Montreal and Toronto later in the month. Overall, though, it's important to keep in mind that while the data have been showing strong gains both north and south of the border for the months after April, there's nothing I've seen that would change my mind that momentum is about to hit a wall. Fiscal stimulus looks set to wane.at the same time, more of the unemployment seems to be in the permanent category rather than temporary like it was at the end of April. That dynamic is more akin to a typical recession and will likely take years, not months, to fully work down. Well, I just completed my first solo episode of Curve Your Enthusiasm, and I've done a lot of talking, so I'm going to leave it there. We'd love to hear from you. Let us know what you think of the show and tell us what topics you'd like to hear about in the weeks ahead. And remember, as always, no bonds were hurt in the making of this podcast.
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