Tuesday, 4 October 2016

Global Monetary Spillovers and Bank of Canada Independence

In a recent post, I discussed The Breakdown of Faith in Unconventional Monetary Policy. Zero interest rate policy (ZIRP), quantitative easing (QE), forward guidance on policy rates and, more recently, negative interest rate policy (NIRP) have been undertaken in various forms and to varying degrees by the four major DM central banks, the US Federal Reserve (Fed), the European Central Bank (ECB), the Bank of Japan (BoJ) and the Bank of England (BoE). Some smaller central banks have dabbled in unconventional monetary policies (UMPs), including the Swiss, Danish and Swedish central banks. 

But, from the perspective of other countries, where the domestic central banks have not been aggressive participants in UMP, the important question is how do these policies affect their economies, their financial markets and the independence of their monetary policies. Recent research has focused on the global spillovers from UMPs of the major central banks into the monetary policies and financial conditions of other global economies, especially EM economies and some of the small open DM economies. This research has found strong evidence that UMP has spilled over into other economies, complicating the conduct of national monetary policies and, at times, creating risks to financial stability.

Evidence of Spillovers

In a their paper, International Monetary SpilloversBoris Hofmann and Előd Takáts of the Bank for International Settlements (BIS) state that:
We find economically and statistically significant spillovers from the United States to EMEs [emerging market economies] and smaller advanced economies [including Canada]. These spillovers are present not only in short- and long-term interest rates but also in policy rates. In other words, we find that interest rates in the United States affect interest rates elsewhere beyond what similarities in business cycles or global risk factors would justify. We also find that monetary spillovers take place under both fixed and floating exchange rate regimes.

Jaime Caruana, General Manager of the BIS, in a recent paper entitled, The international monetary and financial system: eliminating the blind spot, makes the following observation:
Most central banks target domestic inflation and let their currencies float, or follow policies consistent with managed or fixed exchange rates in line with domestic policy goals. Most central banks interpret their mandate exclusively in domestic terms. … [L]iquidity conditions often spill over across borders and can amplify domestic imbalances to the point of instability. In other words, the international monetary and financial system as we know it today not only does not constrain the build-up of financial imbalances, it also does not make it easy for national authorities to see these imbalances coming. 
Moreover, the search for a framework that can satisfactorily integrate the links between financial stability and monetary policy is still work in progress with some way to go. The development and adoption of such a framework represent one of the most significant and difficult challenges for the central bank community over the next few years. 
Caruana has identified four channels by which global liquidity conditions can spill over:

  1. through the conduct of monetary policy: easy monetary conditions in the major advanced economies spread to the rest of the world via policy reactions in the other economies (e.g., easing to resist currency appreciation and maintain competitiveness);
  2. through the international use of currencies: most notably, the domains of the US dollar and the euro extend so broadly beyond their respective domestic jurisdictions that US and euro area monetary policies immediately affect financial conditions in the rest of the world. … A key observation in this context is that US dollar credit to non-bank borrowers outside the United States has reached $9.2 trillion, and this stock expands on US monetary easing;
  3. through the integration of financial markets, which allows global common factors to move bond and equity prices. Uncertainty and risk aversion, as reflected in indicators such as the VIX index, affect asset markets and credit flows everywhere; and 
  4. through the availability of external finance in general, regardless of currency: capital flows provide a source of funding that can amplify domestic credit booms and busts. In the run-up to the global financial crisis, for instance, cross-border bank lending contributed to raising credit-to-GDP ratios in a number of economies.

Caruana concludes:
Through these channels, monetary and financial regimes can interact with and reinforce each other, sometimes amplifying domestic imbalances to the point of instability. Global liquidity surges and collapses as a result. What I have just described is the spillovers and feedbacks – and the tendency to create a global easing bias – with monetary accommodation at the centre. But these channels can also work in the opposite direction, amplifying financial tightening when policy rates in the centre begin to rise, or even seem ready to rise – as suggested by the taper tantrum of 2013.

Implications of Spillovers for Canada

For smaller, open DM economies like Canada, the spillovers from the major central banks’ UMPs are readily visible. 

When the major central banks lowered their policy rates to near zero, the Bank of Canada (BoC) did likewise. This was partly driven by concerns about domestic economic weakness and partly to resist appreciation of the Canadian dollar and the resulting loss of competitiveness. When the BoC became concerned about what proved to be a temporary increase in inflation and raised its policy rate in 2011, the Canadian dollar appreciated strongly.

When major central banks engaged in Quantitative Easing, through large-scale purchases of their own sovereign debt, demand for close substitutes like Canadian sovereign debt increased and forced down Canadian long term government bond yields.

When major central banks, including the Bank of Japan, ECB and BoE moved to NIRP, the Bank of Canada announced that its research showed that it, too, could lower its policy rate below zero if necessary.  

The net result is that Bank of Canada policy has become both constrained by and heavily influenced by the UMPs of the major central banks. Canadian liquidity and financial conditions reflect not just the BoC’s policy rate setting, but also and more importantly, the extraordinarily accommodative policies of the major central banks. The BoC has had no choice but to keep its policy rate low. Failing to do so would have created even greater exchange rate appreciation that would have stunted growth even more and pushed inflation even further below the 2% target.

The ultra-low interest rates imported through global financial markets, have led to a credit boom. The credit boom has been characterized by heavy borrowing by Canadian households and some sectors of Canadian business, such as the energy sector. 

The heavy mortgage borrowing by households has contributed to overheated housing markets in Vancouver and Toronto. As I have argued in a previous post, the housing boom in these cities was amplified by easy credit policy by the People's Bank of China (PBoC), which saw synchronized housing price surges in large Chinese and Canadian cities. With inflation below target and the BoC unable to raise its policy rate to quell this overheating, federal, provincial and municipal governments have intervened with macro-prudential policies, such as tighter mortgage rules, the recent tax on foreign homebuyers in Vancouver, and the federal government's closing of the capital gains tax loophole for foreign homebuyers.

When energy prices were high, supported by near-zero policy rates and the liquidity boost provided by quantitative easing by the major central banks, Canadian energy companies issued large amounts of corporate debt at low rates. When the surge in global investment in fracking technology spurred strong growth in energy supply at a time of lacklustre demand growth, energy prices collapsed and default rates jumped sharply in the energy sector. 

The integration of global financial markets means that global uncertainty and risk aversion is instantly transmitted to Canadian markets for stocks and bonds. Canadian markets and asset prices are now as sensitive, if not more sensitive, to changes in policies of the major central banks as they are to changes in Bank of Canada policy.

Monetary Spillovers and Central Bank Independence

This raises the important question of whether the central banks of smaller open economies, like Canada, can pursue independent monetary policy.

Canada's Nobel Prize winning economist, Robert Mundell, laid the groundwork with what he referred to as "the impossible trinity" and what others have called the "monetary trilemma". As explained by Paul Krugman in 1999,

Mundell proposed the concept of the "impossible trinity"; free capital movement, a fixed exchange rate, and an effective monetary policy. The point is that you can't have it all: A country must pick two out of three. It can fix its exchange rate without emasculating its central bank, but only by maintaining controls on capital flows (like China today); it can leave capital movement free but retain monetary autonomy, but only by letting the exchange rate fluctuate (like Britain--or Canada); or it can choose to leave capital free and stabilize the currency, but only by abandoning any ability to adjust interest rates to fight inflation or recession.

Wikipedia summarizes with the help of the diagram below: "The Impossible Trinity" or "The Trilemma", in which two policy positions are possible. If a nation were to adopt position a, for example, then it would maintain a fixed exchange rate and allow free capital flows, the consequence of which would be loss of monetary sovereignty.

When Canada let its exchange rate float in 1970, it opted for position b on the chart, accepting the need for a flexible exchange rate because it wanted to maintain free international capital mobility and a sovereign (i.e., independent) monetary policy.

But global monetary policy spillovers now challenge the ability of smaller central banks to conduct an independent monetary policy, even if the central bank is prepared to maintain a flexible, market-determined exchange rate. 

In a paper entitled Dilemma not Trilemma: The Global Financial Cycle and Monetary Policy Independence, Hélène Rey of the Kansas City Fed argues,
[M]onetary policy [of] the center country [i.e. the major central banks] … affects leverage of global banks, credit flows and credit growth in the international financial system. This channel invalidates the "trilemma", which postulates that in a world of free capital mobility, independent monetary policies are feasible if and only if exchange rates are floating. Instead, while it is certainly true that countries with fixed exchange rates cannot have independent monetary policies in a world of free capital mobility, my analysis suggests that cross-border flows and leverage of global institutions transmit monetary conditions globally, even under floating exchange-rate regimes.

Implications for Canadian Monetary Policy 

At a minimum, it is high time that the Bank of Canada openly analyze and discuss with the public, the influence that the major central banks' unconventional monetary policies are having on the Canadian economy and financial markets.

How will the future paths of the major central banks policies influence and constrain the policies of the Bank of Canada?

With the Fed signalling that it plans to resume a gradual tightening of policy at a time when the Canadian economy is struggling to adjust to much lower prices for oil and other commodities, the likely spillover will be a premature and possibly excessive, tightening of Canadian financial conditions. Should the Bank of Canada keep pace with Fed tightening or hold the line on Canada’s policy rate and thereby encourage further depreciation of the Canadian dollar? Or should it cut its own policy rate to offset the spillover of tighter financial conditions arising from Fed tightening?

If Fed tightening pushes up global bond yields (and therefore Canadian mortgage rates) how should the BoC respond to the likely fallout in the Canadian housing market if housing prices experience a sharp correction? 

If US and global growth falters and the Fed returns to more aggressive use of UMP, including a zero or even negative Fed policy rate and a resumption of QE, can the BoC afford not to follow?

If the BoJ and/or the ECB push policy rates further into negative territory, should the Bank of Canada be prepared to follow?

If Japan adopts ‘helicopter money’ or central bank financed fiscal stimulus, should the BoC consider the same direction?

Is there any alternative to mimicking the unconventional policies of the major foreign central banks? If the answer is yes, then how will the tradeoffs between the interests of savers and borrowers and between the interests of exporters and domestic consumers be balanced? 

If the answer is no, then what remains of the independence of the BoC? If its' policy rate and Canadian bond yields reflect spillovers from foreign central bank UMPs can the BoC independently pursue its' 2% inflation target? Are its policies not then dominated by foreign central bank actions or possibly by its own government’s needs to finance new spending and hold down debt service costs through financial repression?

These are tough and important questions that are not even being discussed in Canada.

Sunday, 2 October 2016

Global ETF Portfolios for Canadian Investors: 3Q16

The stay-at-home strategy continued to perform well in 3Q16 after three years of underperforming the globally diversified ETF portfolios that we track in this blog. Crude oil prices finished September little changed from where they were at the end of June. The US Fed remained on hold but laid the groundwork for another tightening move before the end of the year. Meanwhile, the Bank of Canada stood pat and talked of rates staying low for long.

The price of WTI crude oil, which began the year at US$37 per barrel finished 3Q16 at US$48/bbl, virtually unchanged from the 2Q closing level. The BoC decision to stand pat, combined with the Fed continuing to signal one tightening before yearend, sparked a 1.6% depreciation in the Canadian dollar in 3Q, ending September at US 76.2 cents, down from 77.4 cents at the end of June.

Flat crude oil prices combined with the 1.6% depreciation in the Canadian dollar in 3Q16 provided modest headwinds for stay-at-home portfolios. Unhedged global ETF portfolios were able to outperform in a quarter when both stocks and bonds continued to rally. A stay-at-home 60/40 investor who invested 60% of their funds in the Canadian equity ETF (XIU), 30% in the Canadian bond ETF (XBB), and 10% in the Canadian real return bond ETF (XRB) had a total return (including reinvested dividend and interest payments) of 4.0% in Canadian dollars. Most of the unhedged Global ETF portfolios that I track in this blog posted slightly stronger gains for 3Q16. Since we began monitoring at the beginning of 2012, the unhedged Global ETF portfolios have vastly outperformed the stay-at-home portfolio.

Global Market ETFs: Performance for 3Q16

In 3Q16, with central banks remaining dovish and the USD appreciating 1.6% against the CAD, global ETF returns favoured foreign equities. In CAD terms, 18 of the 19 ETFs we track posted positive returns, while just one ETF posted a loss for the quarter. The chart below shows 3Q16 returns (blue bars) and year-to-date returns (green bars), in CAD terms, including reinvested dividends, for the ETFs tracked in this blog.

The best gainers in 3Q16 were global equity ETFs, including Japan equities (EWJ) which returned 10.8% in CAD terms, followed closely by US small cap equities (IWM) at 10.7% and emerging market equities (EEM) at 10.2%. The best performing bond ETFs were US High Yield Bonds (HYG) which returned 6.1% in 3Q16, followed by non-US inflation-linked bonds (WIP)  at 5.4%. The Gold ETF (GLD) returned 1.0%. The worst performer was the commodity ETF (GSG) which returned -3.0% in CAD terms.

For 2016 year-to-date, the best performing ETFs in CAD terms were the gold ETF (GLD), the Canadian equity ETF (XIU), and the Canadian long bond ETF (XLB). The worst year-to-date performers were Eurozone equities (FEZ), commodities (GSG) and Japanese equities (EWJ).

Global ETF Portfolio Performance for 3Q16

In 3Q16, the Global ETF portfolios tracked in this blog all posted solid returns in CAD terms. This was true whether USD currency exposure was hedged or left unhedged, but the unhedged portfolios performed better, reversing the pattern of the previous two quarters.

A stay-at-home, Canada-only 60% equity/40% Bond Portfolio returned 4.0% in 3Q16. Among the global ETF portfolios that we track, risk balanced portfolios outperformed in 3Q16. A Global Levered Risk Balanced (RB) Portfolio, which uses leverage to balance the expected risk contribution from the Global Market ETFs, benefitting from strong levered bond returns, gained 4.7% in CAD terms if unhedged, but had a lower return of 3.4% if USD-hedged. An Unlevered Global Risk Balanced (RB) Portfolio, which has less exposure to government bonds, inflation-linked bonds and commodities but more exposure to corporate credit, gained 4.4% if unhedged and 3.2% if USD-hedged.

The Global 60% Equity/40% Bond ETF Portfolio (which includes both Canadian and global equity and bond ETFs) returned 4.4% in CAD terms when USD exposure was left unhedged, and 3.2% if the USD exposure was hedged. A less volatile portfolio for cautious investors, the Global 45/25/30, comprised of 45% global equities, 25% government and corporate bonds and 30% cash, gained 3.9% if unhedged and 2.9% if USD hedged.

On a year-to-date basis, the all Canadian stay-at-home ETF portfolio remained the best performer, returning 10.7% ytd, outperforming all of the unhedged global ETF portfolios that we monitor in CAD terms. If USD exposures were hedged, however, the best performing portfolio was the Global Levered Risk Balanced Portfolio, which returned 15.0% in CAD terms.

Looking Ahead

The key market events of 2016 that have influenced global ETF portfolio returns in CAD terms were: the market's rising conviction that slow global growth and below-target inflation in the major DM economies will delay and moderate any tightening by the Fed and encourage further easing by other major central banks; the BoC's signalling that its policy rate will likely remain low for long; and a gradually improving balance between global demand and supply of crude oil. These events occurred against a backdrop of further downward revisions to global growth  and inflation expectations and rising political uncertainty as the UK voted for Brexit and the polls tightened in the US presidential election race. So far, markets have shrugged off the political uncertainty and been encouraged by continued extremely accommodative monetary policies.

After rising at a 2.5% annualized pace in 1Q, Canada's economy contracted at a 1.6% pace in 2Q, in part due to the disruption caused by the Fort McMurray wildfires. The expected 3Q16 rebound in growth is encouraging but in reality only returns the Canadian economy to subpar year-over-year growth of just over 1%. US growth averaged just 1.1% in the first half of 2016, and the Atlanta Fed's GDP Now forecast currently points to 2.4% growth for US real GDP in 3Q. On balance, 2016 growth expectations have been revised down quite sharply, for Canada to 1.2% currently from 1.9% in December and for the US to 1.5% currently from 2.4% in December.

Global growth and inflation prospects have also cooled. According to JPMorgan, global growth for 2016 is now projected at 3.1%, down from the December consensus forecast of 3.4%. Global consumer price inflation is now projected at 2.3%, down from the December consensus forecast of 2.7%. 

Meanwhile, Fed Chair Janet Yellen's message has shifted from firmly on hold ahead of the Brexit referendum to clear support for a rate hike before the end of 2016 now. At the same time, the Bank of  Canada Governor Poloz has made it clear that the BoC is content to pass the stimulus baton to Finance Minister Morneau, who will soon present a Fiscal Update that will confirm that the government is content to pursue large and growing deficits in the name of "growing the economy".

The key event in the final quarter of 2016 is, without a doubt, the US presidential election. While it can be argued that Trump's economic policy platform, if effectively implemented, would be more advantageous to Canada than Clinton's, there is no doubt that the Canadian voters who gave the Trudeau Liberals a strong parliamentary majority would prefer to see Clinton win. From a market perspective, it appears that risk markets that have so heavily depended on central bank unconventional monetary policies, would prefer a Clinton victory as more likely to see a shift toward a more expansionary fiscal policy and perhaps eventually "helicopter money". 

This leaves global markets in a potentially vulnerable position. Equity market valuations are increasingly stretched. Government bond market valuations also remained stretched as global 10-year bond yields continue to test new lows.

The declines in global bond yields are a reflection of growth disappointments and falling inflation expectations around the world and the market's assessment that this will result in continued experimentation with unconventional monetary policies. We are living in an upside down world in which weak growth and disinflation seem to lift financial asset prices because investors expect that such outcomes will spur even more accommodative monetary policy.

In a continuing uncertain environment, characterized by sluggish global growth, record high debt levels, unprecedented central bank stimulus, and a high level of political risk, remaining well diversified across asset classes, with substantial exposure to USD-denominated assets and with an ample cash position continues to be a prudent strategy.

Wednesday, 14 September 2016

The Breakdown of Faith in Unconventional Monetary Policy

We are witnessing a breakdown of faith, outside central banks, in unconventional monetary policy (UMP). In recent days and weeks, the attack on UMP has intensified from a wide array of analysts including current and former monetary officials as well as highly regarded financial market commentators. 

Inside central banks, faith remains strong, as witnessed at the Jackson Hole meetings in August, where the keynote speaker, Fed Chair Janet Yellen concluded,
New policy tools, which helped the Federal Reserve respond to the financial crisis and Great Recession, are likely to remain useful in dealing with future downturns. 
As unconventional policy comes under attack, central bank credibility is eroded and diametrically opposing views are forming over what direction monetary policies should take next. 

Opponents of UMP favour a gradual unwinding of unconventional monetary policies of key central banks, namely the US Federal Reserve, the Bank of Japan (BoJ) and the European Central Bank (ECB), including quantitative easing (QE) and negative interest rate policy (NIRP).

Supporters of UMP favour even more aggressive use of these policies, by both the BoJ and the ECB to combat slow growth and deflation now.  Some advocate going further to implement "helicopter money" or monetary financing of new fiscal stimulus. 

Which of these policy scenarios plays out over the next few years will dramatically influence both economic and financial market outcomes, not only in the economies of the central banks employing unconventional policies, but across the global economy as the spillovers from the policies of the major central banks reverberate through global financial conditions.

The Critique of Unconventional Monetary Policy

Perhaps the most damaging critiques of UMP have come from current and former monetary officials.

In July, Claudio Borio, Head of the Monetary and Economic Department at the Bank for International Settlements (BIS), along with his colleague Anna Zubai, published a paper titled "Unconventional monetary policies: a re-appraisal". The paper traces the use of UMP and reviews the evidence on the impact of such policies. Borio and Zubai wrote,
They were supposed to be exceptional and temporary – hence the term “unconventional”. They risk becoming standard and permanent, as the boundaries of the unconventional are stretched day after day.
Following the Great Financial Crisis, central banks in the major economies have adopted a whole range of new measures to influence monetary and financial conditions. … But no one had anticipated that they would spread to the rest of the world so quickly and would become so daring.
[T]his development is a risky one. Unconventional monetary policy measures, in our view, are likely to be subject to diminishing returns. The balance between benefits and costs tends to worsen the longer they stay in place. Exit difficulties and political economy problems loom large. Short-term gain may well give way to longer-term pain. As the central bank’s policy room for manoeuvre narrows, so does its ability to deal with the next recession, which will inevitably come. The overall pressure to rely on increasingly experimental, at best highly unpredictable, at worst dangerous, measures may at some point become too strong. Ultimately, central banks’ credibility and legitimacy could come into question.
In August, just as central bankers were congregating at Jackson Hole, Wyoming for their annual get-together, former Federal Reserve Governor Kevin Warsh published another, more strongly-worded, broadside against UMP in an op-ed in the Wall Street Journal.
The conduct of monetary policy in recent years has been deeply flawed. 
The economics guild pushed ill-considered new dogmas into the mainstream of monetary policy. The Fed’s mantra of data-dependence causes erratic policy lurches in response to noisy data. Its medium-term policy objectives are at odds with its compulsion to keep asset prices elevated. Its inflation objectives are far more precise than the residual measurement error. Its output-gap economic models are troublingly unreliable.
The Fed seeks to fix interest rates and control foreign-exchange rates simultaneously—an impossible task with the free flow of capital. Its “forward guidance,” promising low interest rates well into the future, offers ambiguity in the name of clarity. It licenses a cacophony of communications in the name of transparency. And it expresses grave concern about income inequality while refusing to acknowledge that its policies unfairly increased asset inequality. 
At the Jackson Hole meeting, Christopher Sims, the influential Professor of Economics at Princeton University, attempted to answer the question of why unconventional monetary policies, including negative policy interest rates, have been ineffective in boosting growth and returning inflation to target levels, with the following assessment:
Reductions in interest rates can stimulate demand only if they are accompanied by effective fiscal expansion. For example, if interest rates are pushed into negative territory, and the resources extracted from the banking system and savers by the negative rates are simply allowed to feed through the budget into reduced nominal deficits, with no anticipated tax cuts or expenditure increases, the negative rates create deflationary, not inflationary, pressure.
These critiques from current and former monetary policy insiders, give added weight to the arguments against UMP that have been coming from private sector analysts for years. To quote a few recent examples,

James Grant, Publisher, Grants Interest Rate Observer: 
What is new is the medication of markets through this opiate of quantitative easing year after year after year following the financial crisis. I think that this kind of intervention has not only not worked but it has been very harmful.   
 John Hussman, President, Hussman Econometrics Advisors:
By driving interest rates to zero, central banks intentionally encouraged investors to speculate long after historically dangerous ‘overvalued, overbought, overbullish’ extremes emerged. In my view, this has deferred, but has not eliminated, the disruptive unwinding of this speculative episode. By encouraging a historic expansion of public and private debt burdens, along with equity market overvaluation that rivals only the 1929 and 2000 extremes on reliable valuation measures, the brazenly experimental policies of central banks have amplified the sensitivity of the global financial markets to economic disruptions and shifts in investor risk aversion. 
The Fed has insisted on slamming its foot on the gas pedal, refusing to recognize that the transmission is shot. So instead, the fuel is instead just spilling around us all, waiting for the inevitable match to strike. We can clearly establish that activist monetary policy - deviations from measured and statistically-defined responses to output, employment and inflation - have had no economically meaningful effect, other than producing a repeated spectacle of Fed-induced, speculative yield-seeking bubbles. 
Russell Napier, Strategist and Co-founder of the Electronic Research Exchange (ERIC)
Negative interest rates could, if filtered through into deposits in any significant way, lead people to prefer the banknote to the deposit. That used to be called a bank run.
"Policy Singularity" refers to the time when monetary and fiscal policy can no longer be distinguished. It is the final step in Bernanke’s famous helicopter speech. Briefly, the steps [taken by central banks] included quantitative easing; effectively pegging the yield curve; providing forward guidance; putting up the inflation target; and foreign-exchange intervention. The Bank of Japan has run through the entire range of Bernanke’s recommendations apart from the last one, which he calls helicopter money.  
At this moment I still fret more about the outbreak of deflation than inflation, but such concerns would have to be abandoned if ‘helicopter money’ were implemented. The likelihood of their eventual implementation grows by the day as the failure of monetary policy becomes more evident. ‘Helicopter money’ will produce higher levels of broad money growth and inflation. Crucially, the state will not respond by lifting policy rates to control such inflation. Crucially, the state will not allow the yield curve to reflect rising inflation expectations or debts, particularly short-term debts, cannot be inflated away. Crucially, the state will not allow the private sector to gorge itself on credit, the natural reaction when inflation is higher than interest rates. ... This analyst meets few investors who don’t see that financial repression, the process through which the state manipulates the yield curve to below the rate of inflation, is the policy of choice for the developed world.
A summary of the critique of Unconventional Monetary Policy would include the following points:

  1. There is little evidence (according to the BIS and others), that the UMP implemented since the Great Financial Crisis has provided a significant, lasting boost to either economic activity or inflation.
  2. There is strong evidence that UMP has had a significantly inflated real and financial asset prices. This has contributed to the widening inequality of income and wealth.
  3. Even if there are short term benefits of UMP, these are subject to diminishing returns and raise the risk of fuelling speculative bubbles. When such bubbles burst, the dislocations tend to feed through to the real economy, possibly triggering recession and/or deflation. 
  4. Increasingly aggressive UMP narrows the room to maneuver of central banks and risks leaving them with limited policy choices for dealing with the next recession.
  5. When the next downturn comes, central banks will be under political pressure to experiment with even more dangerous forms of UMP, including helicopter money (money financed fiscal stimulus).
  6. Central banks' independence is reduced as monetary policy becomes the servant of fiscal policy and the objective of targeting inflation gives way to the imperative of financial repression as the government requires that interest rates be held below the rate of inflation so that government debt can be inflated away.
  7. Breakdown of faith in UMP threatens central bank credibility and legitimacy.

What is the Future of UMP?

Just because thoughtful people outside of central banks are losing faith in UMP does not mean that the decision-makers of the major central banks are planning to change their approach to monetary policy. On the contrary, it seems that advocates of UMP are committed to taking even more aggressive actions if their targets for economic growth and inflation continue to be unmet.

The central bankers and academics who gathered at Jackson Hole, perhaps anticipating and responding to the growing criticism of UMP, made the theme of their symposium "Designing Resilient Monetary Policy Frameworks for the Future". Fed Chair Janet Yellen left little doubt that, in her opinion, UMP will play an important and possibly increased role in future monetary policy. In the event that the current expansion falters and the economy moves toward a recession, Yellen suggested that the tools of UMP would be resorted to once again: 

In addition to taking the federal funds rate back down to nearly zero, the FOMC could resume asset purchases and announce its intention to keep the federal funds rate at this level until conditions had improved markedly--although with long-term interest rates already quite low, the net stimulus that would result might be somewhat reduced.
Despite these caveats, I expect that forward guidance and asset purchases will remain important components of the Fed's policy toolkit. ... That said, these tools are not a panacea, and future policymakers could find that they are not adequate to deal with deep and prolonged economic downturns. For these reasons, policymakers and society more broadly may want to explore additional options for helping to foster a strong economy.
On the monetary policy side, future policymakers might choose to consider some additional tools that have been employed by other central banks, though adding them to our toolkit would require a very careful weighing of costs and benefits and, in some cases, could require legislation. For example, future policymakers may wish to explore the possibility of purchasing a broader range of assets. Beyond that, some observers have suggested raising the FOMC's 2 percent inflation objective or implementing policy through alternative monetary policy frameworks, such as price-level or nominal GDP targeting.
In fact, Chair Yellen while solidly behind UMP measures adopted to date, was far from the most enthusiastic UMP advocate at Jackson Hole. Professor Marvin Goodfriend of Carnegie-Mellon University argued that, "It is only a matter of time before another cyclical downturn calls for aggressive negative nominal interest rate policy actions". The aforementioned Christopher Sims called for helicopter money financed fiscal stimulus as follows, "What is required is that fiscal policy be seen as aimed at increasing the inflation rate, with monetary and fiscal policy coordinated on this objective". Finally, Bank of Japan Governor Kuroda, who has overseen the most aggressive UMP to date, has no qualms about pushing ahead even further,
Looking ahead, the Bank of Japan will continue to carefully examine risks to economic activity and prices at each monetary policy meeting and take additional easing measures without hesitation in terms of three dimensions -- quantity, quality, and the interest rate -- if it is judged necessary for achieving the price stability target. QQE with a Negative Interest Rate is an extremely powerful policy scheme and there is no doubt that ample space for additional easing in each of these three dimensions is available to the Bank. The Bank will carefully consider how to make the best use of the policy scheme in order to achieve the price stability target of 2 percent, and will act decisively as we move on.

The Risks That Lie Ahead

With a developing professional view that UMP has gone too far, is subject to diminishing returns, and that short term gains from such policies are likely to give way to long term pain, there are significant risks to both the economy and financial markets no matter what path central banks decide to pursue. 

With the US economy having performed relatively well in the disappointing global expansion since the GFC, the Fed is in the strongest position to begin to remove unconventional monetary stimulus. Indeed, the Fed has already begun to do so by tapering quantitative easing, by lifting the policy rate by 25 basis points last December, and by providing forward guidance that the policy rate would continue to rise. However, each of these steps have caused corrections in global markets for risk assets and sharply increased volatility. The greatest volatility has come in China and other highly-geared emerging markets as the promise of tighter US financial conditions has spilled over into tighter global financial conditions. In response to this volatility and to slowing economic growth, the Fed has pushed back the timing of it plans for hiking the policy rate and eventually reducing the size of its' balance sheet.

Meanwhile, in an environment of slowing global growth and deflationary pressures, the adoption of negative policy interest rates, as well as continued large scale purchases of government bonds, by the BoJ and the ECB have pulled global bond yields down. At the low point in global bond yields, as much as US$13  trillion of government bonds had negative yields. Despite the Fed's intentions to reduce monetary stimulus, US bond yields fell to near record lows. In Canada, where the BoC has been sitting on its hands for over a year, the effect of foreign central banks' UMP has pushed bond yields to new lows, with the 10-year Canada bond yield falling below 1%. 

The fall in global bond yields has had three effects: it has reduced mortgage borrowing costs which has boosted prices and encouraged speculative activity in housing markets; it has caused investors to reach for yield in risky investments; and it has encouraged even highly-indebted governments to relax fiscal discipline by boosting debt-financed infrastructure spending plans.  

As consumer, corporate and government debt all continue to grow faster than nominal GDP, it becomes increasingly dangerous for central banks to remove monetary accommodation. Monetary policy increasingly becomes hostage to the need for financial repression, that is for interest rates to be pegged below the rate of inflation so that debt can be inflated away. Inflation targeting becomes less attainable and politically less popular.

Pushing further into unconventional monetary policies, say by moving towards "helicopter money", also known as central bank financed fiscal stimulus, might provide some short-term gain (as has resulted from other less drastic forms of UMP), it is also likely to result in even more long term pain.

Saturday, 2 July 2016

Global ETF Portfolios for Canadian Investors: 2Q16 Review and Outlook

The stay-at-home strategy continued to perform well in 2Q16. The major forces that drove markets in 2015 have reversed in the first half of this year. Crude oil prices have rebounded and the monetary policy divergences between the US Fed and the Bank of Canada have narrowed.

The price of WTI crude oil, which began the year at US$37 per barrel and touched a 12-year low of just over US$26/bbl in February, then rallied back to finish 2Q16 at US$48/bbl. On the monetary policy front, the Fed, which had contemplated as many as four policy rate hikes in 2016, is now not expected to raise rates even once. The BoC, after anticipating the Liberal government's promised fiscal stimulus, went on hold in January and remains firmly on hold. The BoC decision to stand pat, combined with the Fed backing off on tightening, sparked a 12% rally in the Canadian dollar from the January low of 68.6 US cents to 76.8 cents by the end of March. After rallying further to test the 80 cents level in early May, the Canadian dollar fell back at the end June to 77.4 cents, amid risk aversion related to Brexit and signs that Canada's real GDP growth had stalled in 2Q. 

The rise in crude oil prices combined with the 0.7% gain in the Canadian dollar in 2Q16 provided tailwinds for stay-at-home portfolios while unhedged global ETF portfolios were able to recoup some of their losses sustained in the first quarter. A stay-at-home 60/40 investor who invested 60% of their funds in the Canadian equity ETF (XIU), 30% in the Canadian bond ETF (XBB), and 10% in the Canadian real return bond ETF (XRB) had a total return (including reinvested dividend and interest payments) of 3.7% in Canadian dollars. All of the unhedged Global ETF portfolios that I track in this blog posted gains for 2Q16. Since we began monitoring at the beginning of 2012, however, the unhedged Global ETF portfolios have vastly outperformed the stay-at-home portfolio. 

Global Market ETFs: Performance for 2Q16

In 2Q16, with the USD depreciating 0.7% against the CAD, global ETF returns favored commodities and bonds. In CAD terms, 17 of the 19 ETFs we track posted positive returns, while 2 ETFs posted losses for the quarter. The chart below shows 2Q16 returns in CAD terms, including reinvested dividends, for the ETFs tracked in this blog.

The best gainer in 2Q16 was the commodity ETF (GSG) which returned 11.8% in CAD terms. The Gold ETF (GLD) returned 6.8%, while the Canadian long bond ETF (XLB) returned 5.3% in CAD terms. Other ETFs with strong returns for the quarter included Emerging Market Bonds (EMB) 4.9%; US High Yield Bonds (HYG) 4.5%; and Canadian equities (XIU) 4.2%.

The worst performers, were the Eurozone equity ETF (EWJ) and the Eurozone equity ETF (FEZ), which returned -4.4% and -0.3%, respectively in CAD terms. 

For 2016 year-to-date, the best performing ETFs in CAD terms were gold, the Canadian long bond and the Canadian equity ETF. The worst year-to-date performers were Eurozone, Japan (EWJ), US small cap (IWM), and US large cap equities (SPY).   

Global ETF Portfolio Performance for 2Q16

 In 2Q16, the Global ETF portfolios tracked in this blog all posted positive returns in CAD terms. This was true whether USD currency exposure was hedged or left unhedged, but the USD hedged portfolios performed better for a second consecutive quarter.  

A stay-at-home, Canada-only 60% equity/40% Bond Portfolio returned 3.7% in 2Q16. Among the global ETF portfolios that we track, risk balanced portfolios outperformed in 2Q16. A Global Levered Risk Balanced (RB) Portfolio, which uses leverage to balance the expected risk contribution from the Global Market ETFs, benefitting from strong levered bond returns, gained 3.8% in CAD terms if USD-unhedged and had an even better gain of +5.1% if USD-hedged. An Unlevered Global Risk Balanced (RB) Portfolio, which has less exposure to government bonds, inflation-linked bonds and commodities but more exposure to corporate credit, gained 2.9% if USD-unhedged and 3.4% if USD-hedged.

The Global 60% Equity/40% Bond ETF Portfolio (which includes both Canadian and global equity and bond ETFs) returned 1.4% in CAD terms when USD exposure was left unhedged, and 1.9% if the USD exposure was hedged. A less volatile portfolio for cautious investors, the Global 45/25/30, comprised of 45% global equities, 25% government and corporate bonds and 30% cash, gained 1.9% if unhedged and 2.2% if USD hedged.

On a year-to-date basis, the all Canadian stay-at-home ETF portfolio has been a solid performer, returning 6.4% ytd, outgunning all of the unhedged global ETF portfolios that we monitor in CAD terms. If USD exposures were hedged, however, the best performing portfolio was the Global Levered Risk Balanced Portfolio, which returned 11.2% in CAD terms.

Looking Ahead

The key market events of the first half of 2016 that influenced global ETF portfolio returns in CAD terms were: the market's rising conviction that the Fed is unlikely to raise rates in 2016; the BoC's decision to eschew further easing; and the improving balance between global supply and demand for crude oil.  These events occurred against a backdrop of further downward revisions to global growth expectations and significant geopolitical uncertainty.

After rising at a 2.4% annualized pace in 1Q, Canada's growth likely stalled in 2Q, in part due to the disruption caused by the Fort McMurray wildfires. Early indications for US growth, based on the Atlanta Fed's GDP Now forecast, point to 2.4% growth for US real GDP in 2Q, after just 1.1% in 1Q. On balance, 2016 growth expectations have been revised down quite sharply, for Canada to 1.5% in June from 1.9% in December and for the US to 1.7% from 2.4%.

Outside Canada and the US, growth prospects have also cooled. The UK real GDP forecast for 2016 has been cut to 1.5% in the wake of Brexit from 2.4% six months ago. Eurozone growth expectations have been marked down to 1.6% from 1.8%. Japan's growth now expected to reach only 0.7%, down from 1.1%. The sharpest cuts in expectations are for emerging market economies, with 2016 growth expectations down to 3.8% from 5.2%.

Meanwhile, Fed Chair Janet Yellen's message has been clear that the Fed will proceed cautiously with tightening, especially in light of the uncertainty trigged by the Brexit vote in the UK. In Canada, with substantial increases in government spending announced in the federal budget providing second half stimulus, the Bank of Canada is signalling that it will remain on hold for some time.  

At the end of March, we said "A sharp decline in worldwide oil and gas exploration and development spending suggests that crude oil production growth will slow, perhaps bringing global oil demand and supply into better balance as 2016 unfolds". That process continued through 2Q16, lifting crude oil prices to test US$50/bbl just before the Brexit vote. The rise in prices has halted the sharp decline in the North American rig count, but energy investment intentions continue to ebb, especially in Canada. Now that oil prices have recovered as seasonal demand for gasoline has hit its high point, the question is whether the crude oil price gains witnessed through 1H16 can be sustained, against a backdrop of sluggish global growth. 

This leaves markets in a similar position to where they were at the beginning of 2016. Equity market valuations remain stretched. Government bond market valuations are even more stretched as US and Canadian 10-year bond yields have fallen to new lows, while German, Swiss and Japanese 10-year yields are all negative.

The declines in global bond yields are a reflection of growth disappointments around the world and the market's assessment that this will result in more accommodative monetary policies than previously thought. Monetary ease has pushed up prices of gold and other commodities and has supported equity prices. We are living in an upside down world in which growth disappointments seem to lift financial asset prices because investors expect that weak growth will spur even more accommodative monetary policy. 

In a continuing uncertain environment, characterized by sluggish global growth, record high debt levels, unprecedented central bank stimulus, and a high level of geopolitical risk, remaining well diversified across asset classes, with substantial exposure to USD-denominated assets and with an ample cash position continues to be a prudent strategy. 

Monday, 27 June 2016

After Brexit: What Canada Should Do Now

After the UK voted for Brexit, Canada's media was overwhelmingly shocked and dismayed. An example was the Globe and Mail editorial, The Brexit vote is complete folly, but there is still time to reverse it. The hyperbole was breathtaking in words such as these,
The foundational tenets of modern capitalism – that free trade brings prosperity and is the surest way of ensuring the peaceful co-existence of nations – have been rejected by one of the most advanced trading nations in the world.
As Colby Cosh points out, the media and the twitterverse, have maligned 17 million UK voters,
Look at the list of imprecations being hurled at Leave voters Friday, many of them by Canadians. They’re “small-minded,” “isolationist,” “short-sighted,” “fact-blind,” “racist” countryside boobs without vision or understanding.
But as Cosh correctly argues, what the Brexiters wanted is what Canada already has,
[T]he intellectual leaders of the Leave camp are constantly upholding Canada as a model for immigration policy, with its self-interested, skill-privileging, but globally indiscriminate points system. They also cite us as an obvious potential partner for the kind of bilateral trade deal Britain will now be free to pursue on its own. Basically, the Leave campaigners didn’t put it this way or incorporate it into a slogan, but they want the U.K.’s relationship with Europe — a polyglot kaleidoscope of radically dissimilar nation states, some of them failing — to be the same friendly, wary relationship Canada has with the United States. 
A few Canadian media voices took a positive view on the Brexit vote, including Terrence Corcoran's op-ed, Don’t be bamboozled, Brexit creates huge opportunities for the U.K.
British voters are proposing to leave a slow-growth fiscal disaster zone mired in sclerotic regulation and over-regulation, persistent protectionism, mismanaged immigration policy and an often corrupt political structure controlled by unaccountable power brokers with occasional thuggish tendencies... Brexit need not imperil EU trade deals with Canada or other nations, unless the EU becomes self-destructively vindictive and uses the Brexit threat to create turmoil in trade relations... Indeed, there is every reason to accelerate the creation of trade deals.
 Canada's political leaders have been relatively quiet. After urging Brits to Remain, Prime Minister Trudeau was booed by a crowd in Quebec City when he said, "We respect the choice of the British people and will remain a strong partner of the UK and the European Union". 

Canada's International Trade Minister, Chrystia Freeland, spoke to her European Union counterpart, Cecilia Malmstrom, and reiterated that Canada remains firm in its commitment to ratifying the Canada-European Union Comprehensive Economic and Trade Agreement​ (CETA). There was no indication that Freeland put in a call to her UK counterpart.

But, as Trevor Tombe points out, the UK accounts for half of Canada-EU trade and is Canada's largest non-US investment partner. 

And as RBC Economics observes, the U.K. has been a "champion of CETA, so the country’s exit from the EU removes an important supporter of the agreement at this crucial juncture". 

In my opinion, Canada needs to get its priorities straight and remember it's history. The most positive and constructive suggestion that I have seen since the Brexit vote has come from none other than Conrad Black, whose opinion piece in the National Post argued,
[T]his is a place where Canada could play a key role, as it could, and should, in reviving the top tier of the Commonwealth (Canada, U.K., Australia, India, Singapore, New Zealand) as a coherent but not artificially united bloc, in close relations with Western Europe and the United States.... It will be ...  a great chance for Canada, if for the first time since the Mulroney era anyone in our Foreign Affairs Ministry has the imagination to grasp it.
Canada should now be the first to step forward with an offer to its oldest ally, the United Kingdom, to negotiate a bilateral free trade agreement with the UK, which could be expanded to include other members of the Commonwealth. At the same time, it should continue to pursue the ratification of CETA and other free trade agreements that advance Canada's interests. 



Thursday, 23 June 2016

China Stimulus and Vancouver House Prices

In March 2014, I posted a note entitled, Why So Paranoid About Canada's Housing Market?, in which I argued that the housing market in Canada's least affordable cities, Vancouver and Toronto, did not seem overvalued relative to other major cities such as Hong Kong, London, Beijing, Singapore, Moscow, Sydney and Melbourne. More than two years later, that conclusion has been borne out, as the Vancouver and Toronto housing markets did not experience sharp corrections, as many were forecasting, but instead posted strong further price gains. 

The post concluded, 
Global central bank policies of low interest rates and massive liquidity provided by quantitative easing have affected all global housing markets, pushing up the value of real assets such as houses relative to the value of money. When central banks withdraw from their extremely easy monetary policies, housing markets in all countries may experience a slowing or a more serious correction. But there is no reason to single out Canada, as the Financial Times did, as “the next global housing market ready to burst”.
In this post, I want to further highlight how the spillovers from other countries monetary policies have affected Canada's most overvalued housing market, Vancouver.

Vancouver's Spiralling Housing Prices

There is no doubt that Vancouver's house prices have moved deeply into bubble territory.

The chart above, from the Real Estate Board of Greater Vancouver, shows that the average price of a detached home in Vancouver has surged by over 30% in there past year to over C$1.8 million (for a clearer view of this chart click here). The epic surge in Vancouver prices pushed RBC's affordability measure for the Vancouver area to 87.6 per cent in 1Q15, the worst ever recorded anywhere in Canada. The annual pace of increases in Vancouver house prices since 2002, as measured by Teranet, is shown in the chart below.

Finance Minister Bill Morneau recently promised that his department was undertaking a "deep dive" into Canada's housing markets to find "real evidence" behind the country's red-hot sector  and the role of foreign investors in those record-high prices. 

Bank of Canada Governor Steven Poloz said this month on the release of the Financial System Review (FSR), that "We are also seeing evidence, particularly in Vancouver but also in Toronto, where expectations of future price changes have become, to a degree, extrapolative and we think that those expectations are probably not going to be realized. The rate of price increase in those markets has been outpacing fundamentals and therefore would be unlikely to be sustained". In the FSR, the Bank of Canada acknowledged that "foreign demand is playing a role in specific sectors of the Vancouver and Toronto housing markets", but noted that the effect is difficult to measure because of the lack of data on foreign home purchases and ownership. 

Participants in both housing markets and financial markets so far have shrugged at these comments. The frenzy to buy homes in Vancouver and Toronto shows no signs of abating. Financial markets are pricing in no greater likelihood of Bank of Canada tightening policy to cool housing markets, as the economy continues to operate below full capacity and growth prospects remain lacklustre. 

Why are Vancouver Prices outpacing "Fundamentals"?

Both Morneau and Poloz noted that fundamentals such as immigration, job growth and income growth are stronger in Vancouver than in other parts of Canada. However, these relatively strong fundamentals cannot explain the strength of house price growth. The unanswered question is why are Vancouver house prices stronger than the fundamentals? Poloz suggests that it is because buyers, sellers and lenders seem to have adopted extrapolative expectations, extrapolating the current pace of price gains into the future. But why have price expectations exploded in these cities and not in other parts of Canada?

In my opinion, the housing markets in Vancouver and, to a lesser extent, in Toronto are responding not only to the extraordinarily easy monetary policies being pursued by the central banks of the US, Eurozone and Japan, but equally importantly to monetary policy in China given the relative ease with which residents of mainland China, Hong Kong and Taiwan are able to purchase real estate in Canada.

When the Chinese government wants to provide stimulus to the economy, it does so by encouraging Chinese banks to increase loan growth for a wide range of activities. When loan growth surges, Chinese house prices tend to post strong gains; and when Chinese house prices post strong gains, Vancouver house prices tend to do the same. The chart below shows four periods in which China loan growth has accelerated, and the behaviour of house prices in Beijing and Vancouver (Beijing data not available for the 1Q02-3Q04 period). 

The chart shows that in the period from 2Q05 to 3Q07, as the US housing bubble was forming, China loan growth accelerated from12% to 17% y/y, Beijing house prices accelerated from 5% to 9% y/y and Vancouver prices surged from 9% to 23% y/y. 

In the period from 4Q08 to 2Q10, in the wake of the Global Financial Crisis, China loan growth surged from 13% to a peak of 33% (in 4Q09), the price of homes in Beijing went from a decline of 1% to a rise of 12% y/y, and Vancouver house price gains rose from 1% to 16% y/y.

In the most recent period, from 3Q14 to 1Q16, a period when China has seen two stock market crashes that have driven nervous investors away from equities, China loan growth has been boosted through stimulus measures from 13% to 15%, as the increase in bank loans hit an all-time record in January. In response to the stimulus, Beijing house price gains accelerated from 2% to 18%y/y and Vancouver house price gains jumped from 7% to 21%. It is worth noting that prices in other big cities in China surged by even more, to over 20%y/y in Shanghai and over 50% y/y in Shenzhen.  It is also worth noting that because the Chinese Yuan (CNY) appreciated by about 11% versus the Canadian dollar over the period, Vancouver house prices actually became more affordable for Chinese buyers (in CNY terms) relative to homes in Beijing, Shanghai and Shenzhen, even as homes in these cities became much less affordable for the majority of both Chinese and Canadian citizens.

As financial strains have increased in China, there seems little mystery in where much of the government stimulus ends up. It flows from banks through both state-owned and private enterprises to senior officials and highly paid employees and then into home buying, both in major Chinese cities and in cities abroad that are attractive places to own property (although not necessarily to live) and for their children to be educated, such as Vancouver. This process has been well documented in David Ley's insightful book, Millionaire Migrants: Trans-Pacific Life LinesCanadian governments -- federal, provincial and municipal -- have been actively encouraging this type of foreign investment since at least the late-1980s.

While Mr. Poloz is probably correct to say that Vancouver house price expectations have become extrapolative, that the pace of recent price gains in unlikely to be sustained and that the risk of a potentially sizeable house price correction has increased, there is little that the Bank of Canada can or should do about it. As long as global central banks continue to pursue reflationary policies at any cost, keeping policy rates near zero or even negative, and willing to encourage high rates of credit growth even as debt ratios reach new highs, the Bank of Canada cannot raise rates to lean against the housing bubble without further appreciating the Canadian dollar and stifling the export-led growth that the country needs. 

While Poloz is correct that financial stability risks are rising as Vancouver and Toronto house prices grow to the sky, it is the job of Finance Minister Morneau, along with provincial and city officials, to decide what measures might curb the influence of foreign central bank stimulus on Vancouver and Toronto house prices and how these measures might be applied without bringing about the sharp house price correction that everyone fears. This is also probably one of the reasons why what worries the Bank of Canada even more than housing is a concern about financial stress in China

Sunday, 24 April 2016

Why Does the Bank of Canada Now Believe that Fiscal Stimulus Works?

Here are some quotes from a famous article in the November 1963 issue of the Canadian Journal of Economics and Political Science by Nobel Prize winning economist, Robert Mundell, then of McGill University. He is writing about the effect of a fiscal stimulus generated by an increase in government spending financed by borrowing in an economy with a floating exchange rate in a global environment of extremely high international capital mobility.
Increased [government] expenditure creates excess demand for goods and tends to raise income. But this would increase the demand for money, raise interest rates, attract a capital inflow and appreciate the exchange rate, which in turn would have a depressing effect on income. In fact, therefore, the negative effect on income of exchange rate appreciation has to offset exactly the positive multiplier effect on income of the original increase in government spending. Income cannot change unless the money supply or interest rates change. ... Fiscal policy thus completely loses its force as a domestic stabilizer when the exchange rate is allowed to fluctuate and the money supply is held constant. 
If my assumptions about capital mobility were valid in Canada, it would mean that expansive fiscal policy under flexible exchange rates [would be] of little help in increasing employment because of the ensuing inflow of capital which keeps the exchange rate high and induces a balance of trade deficit: we [would observe] a zero or very small multiplier. 
Of course the assumption of perfect capital mobility is not literally accurate... To the extent that Canada can maintain an interest rate equilibrium different from that of the United States, without strong capital flows, fiscal policy can be expected to play some role under flexible exchange rates... But if this possibility exists for us today, we can conjecture that it will exist to a lesser extent in the future.
Mundell's classic "Capital Mobility and Stabilization Policy Under  Fixed and Flexible Exchange Rates" clearly laid out that in a global economy with a high degree of capital mobility, fiscal stimulus in a small open economy operating with a flexible rate is likely to have little if any lasting impact on real GDP growth.

Fast forward 50 years and empirical studies by the US National Bureau of Economic Research (NBER) and by the Bank of Canada confirmed that fiscal multipliers for Canada are very low.

The NBER summarized its results as follows:
Based on a novel quarterly dataset of government expenditure in 44 countries [including Canada], we find that (i) the output effect of an increase in government consumption is larger in industrial than in developing countries, (ii) the fiscal multiplier is relatively large in economies operating under predetermined exchange rates but is zero in economies operating under flexible exchange rates; (iii) fiscal multipliers in open economies are smaller than in closed economies; (iv) fiscal multipliers in high-debt countries are negative. 
Specifically, the NBER found that for economies, like Canada, that are "open to trade or operating under flexible exchange rates, a fiscal expansion leads to no significant output gains. Further, fiscal stimulus may be counterproductive in highly indebted economies. Indeed, in countries with debt levels as low as 60% of GDP, government consumption shocks may have strong negative effects on output".

The Bank of Canada found that while Canada benefits greatly from fiscal stimulus conducted by the United States and other G20 trading partners, "Canada’s high level of openness sharply curtails the effectiveness of a domestic [fiscal] stimulus." Specifically, the 2010 study by BoC researchers found that, for Canada, fiscal multipliers for government spending were very low: ranging from virtually zero for increases in general transfer payments, to 0.40% for government investment expenditures, to 0.80% for government spending on goods, to .98% for spending on government services.

The findings of the NBER and the BoC, corroborate Mundell's theoretical insight and support his view that as global capital markets became ever more efficient, fiscal policy has become ever less powerful in small open economies with flexible exchange rates.

So it is somewhat surprising to me that in recent days, the Governor and the Senior Deputy Governor of the Bank of Canada have gone out of their way to tell members of the press that they believe that Canada's latest fiscal stimulus will have a substantial positive effect on real GDP.

Governor Stephen Poloz told the Canadian Press, "we're fortunate in Canada that we have that fiscal capability right now to shift our policy mix ... as the government has done... This is exactly the setting where fiscal policy is its most effective and its also where monetary policy is its least effective." 

Bloomberg News reported Poloz as saying that the size of the fiscal multiplier depends on the “situation you start in.” When the economy is in equilibrium, government spending triggers higher interest rates and higher currency, crowding out private spending. In equilibrium, fiscal policy “has no effect except it changes the mix of what is going on in the economy. So this gives rise to sort of cavalier statements from some that would say, 'well that won’t have any effect.'" Poloz went on to say that in low growth settings, “fiscal policy begins to add demand in the economy (and) basically nothing else happens except that demand goes up and what happens then is that you get the maximum effect of fiscal policy because there are no offsets such as upward creep in interest rates or movement in the exchange rate.”

BoC Senior Deputy Governor Carolyn Wilkins was singing from the same hymn book in an interview with Macleans magazine, where she opined that fiscal policy is more effective than monetary policy in boosting productivity and growth when interest rates are low. In the interview, she said "If fiscal policy can do some of the heavy lifting, that’s a positive thing. Fiscal policy at low interest rates is also just more effective. In a world where growth is going to be structurally slower because of demographic changes, monetary policy can’t fix that. If we want sustainable growth, we need to boost productivity, not only in Canada [but in] the global economy. That’s the only place growth can come from."

Mr. Poloz seems to be basing his enthusiasm for fiscal policy on the degree of slack in the Canadian economy. Indeed, some studies do indicate that government spending multipliers for OECD countries, on average, are near zero in periods of expansion or low unemployment but are higher in recessions or in periods of very high unemployment. But Canada is not in recession and unemployment is close to the threshold level of 7%, only above which fiscal multipliers might be somewhat higher. And Canada is not an average OECD country; it is a smaller, much more open economy than the US, the Eurozone or Japan and it is much more sensitive to movements in its exchange rate.

Mr. Poloz and Ms. Wilkins seem to be arguing that one of Robert Mundell's Nobel prize winning theoretical insights does not apply to the Canadian economy, the very economy where Mundell pointed out that his theory was most likely to be true. They seem to be arguing that the 2010 empirical results of the NBER and of the BoC's own researchers, which showed zero or very low fiscal multipliers are not to be believed.

I am not convinced. On the contrary, I believe that Mundell's theory is more valid today than it ever was. The economy has some slack as Poloz suggests, but not so much, as by the BoC's estimate it was operating somewhere between 98.3% and 99.4% of full capacity in the first quarter of 2016. One can concede that fiscal stimulus may lead to a short run pickup in growth. However, the market's perception of improved short-term growth even before the budget measures were implemented and the market's anticipation of a further fillip to growth from fiscal stimulus has already raised interest rate expectations compared to what they were when the BoC was still perceived to be in easing mode prior to January 20, when the BoC signalled that it would stand pat. The higher interest rate expectations for Canada, combined with more accommodative monetary stances by the US Fed, the ECB and the BoJ, have already caused the Canadian dollar to appreciate by 15% against the US dollar from its January low. The stronger Canadian dollar has already caused the BoC to downgrade its export growth forecast. As the fiscal stimulus feeds into the economy in 2016 and 2017, growth of private sector production for export markets will be suppressed by the stronger Canadian dollar and will be supplanted by increased public spending on infrastructure and on low multiplier transfer payments. With Canada's G20 trading partners not moving to large-scale fiscal stimulus, the result will be what the BoC researchers predicted in 2010: Canada’s high level of openness and flexible exchange rate will "sharply curtail the effectiveness of domestic fiscal stimulus."

It also seems to suggest that the stance of the BoC's monetary policy relative to our major trading partners is still a very powerful policy instrument.

The eventual outcome of the fiscal stimulus being applied in a non-recessionary economy without similar actions in Canada's trading partners is unlikely to be sustained stronger economic growth. Instead, the cumulative impact on the level of real GDP is likely to be negligible. However, the composition of real GDP and the level of government debt will be affected. 

Real GDP will be shifted away from private sector output of goods and services toward public sector construction output and subsidized green energy projects. With private sector construction of pipelines and LNG terminals stalled by government regulations, and with coal-fired power plants being shut down, productivity seems more likely to fall than to rise, as Ms. Wilkins argues.

Public debt to GDP is already rising and will continue to rise. According to the National Balance Sheet Accounts, total government debt rose to 76.2% of GDP at the end of 2015 from 72.8% a year earlier. Recent federal and provincial budgets suggest that the increase in total government debt to GDP will accelerate over the next few years. This could put Canada quickly into the situation described by the NBER researchers in which fiscal multipliers in high debt countries may have strong negative effects on real GDP.

Finally, even if one believed that fiscal stimulus would work to boost real output and employment on a sustained basis [which I don't], one can only wonder why an independent Bank of Canada did not voice this opinion a year ago when the economy was actually contracting, but then praised stimulus after the newly elected government tabled a budget promising much higher spending and deficits.