Thursday, 20 March 2014

Poloz and Yellen: Rookie Mistakes?

In a speech in Halifax on March 18, Bank of Canada Governor Stephen Poloz gave a downbeat assessment of both near-term and longer-term growth. In the Q&A following the speech, Poloz would not rule out the possibility that the BoC's next move might be a rate cut and the Canadian dollar promplty dropped 0.7%. The following day, Fed Chair Janet Yellen stumbled through a press briefing following the Fed meeting in which quantitative forward guidance was replaced by qualitative guidance. Markets interpreted the Fed statement and Yellen's comments as either more hawkish or just more uncertain and the Canadian dollar dropped another 0.9% to its lowest level in four years.

While the statements of both rookie central bank governors were mostly sensible and moderate, they clearly heightened market uncertainty future monetary policy in both countries and the increased uncertainty reverberated through financial markets.

Poloz speaks of Secular Stagnation

Poloz's speech has the unfortunate title, "Redefining the Limits to Growth", harking back to the 1972 polemic, "The Limits to Growth" published by the Club of Rome. The speech had nothing to do with the Club of Rome's Malthusian warning that exponential growth in a world of finite resources would lead to overshooting and collapse. Instead, the basic message was that demographic forces and the hangover from the global financial crisis together are putting limits on economic growth. 

For Canada, Poloz explained there is an interplay between the aging and the beginning of the retirement of the baby boom generation, the demand for housing and the path of productivity growth. Strong housing growth and weak business investment have lowered productivity growth. The retirement of the baby boomers is slowing labour force growth. As a result, Canada's potential growth rate has slowed to 2% or possibly a bit less. Poloz noted that there is some slack in the economy and said that "we expect growth to approach 2.5% over the next over the next couple of years … This is why we say that it will take a couple of years for us to close our excess capacity gap and get inflation back to near our 2 per cent target". This is quite conventional Bank of Canada thinking which seems to ignore the comments, made by outgoing Senior Deputy Governor Tiff Macklem just two weeks earlier, that the relationship between the output gap and the rate of inflation is small and statistically insignificant. 

Poloz also invited his audience to "dive in" to the argument made by some analysts, notably Larry Summers, that suggests the global economy may be facing a long period of secular stagnation. Poloz opines that "the possibility of secular stagnation needs to be taken seriously… it suggests that interest rates may remain lower than we have experienced in the past for a longer period, until some of these long-term forces dissipate. One specific consequence would be that even extraordinarily low policy interest rates could prove to be less stimulative than in normal circumstances."

Yellen's Fed shifts from Forward Guidance to Fuzzy Guidance

The March 18-19 Federal Open market Committee (FOMC) meeting was widely anticipated for two reasons. It would be the first meeting chaired by Janet Yellen and it was expected that the Fed would shift from the quantitative forward guidance implemented by the Bernanke Fed in 2012 to some form of qualitative guidance. The reason for the shift was that the US unemployment rate had fallen faster than expected to close to the 6.5% that the Fed had earlier indicated would require contemplation of tightening policy. At the same time, US inflation has fallen to just over 1% and the Fed had already made it clear that while its plan to taper the stimulus provided by its bond purchases would proceed, that it expected the policy rate to remain extraordinarily low for an extended period.

The FOMC statement announced that with the unemployment rate approaching 6.5%, the Committee is updating it's forward guidance as follows: 

  • "In determining how long to maintain the current 0 to 1/4 percent target range for the federal funds rate, the Committee will assess progress--both realized and expected--toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments."

The statement also said that, 

  • "The change in the Committee's guidance does not indicate any change in the Committee's policy intentions as set forth in its recent statements", and  
  •  "It will likely be appropriate to maintain the current target range for the federal fund rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the policy committee’s 2% longer-run goal. 

In the press conference, when pressed to define "a considerable time", Yellen said, "Something on the order of six months, or that type of thing". Although the response was not substantially different from what markets have been expecting, the US stock market fell sharply on the comment.

Then there was the matter of the "dot plots". When the Fed updates its forecasts it polls members of the FOMC as to where they expect the Fed funds rate to be at points in the future. Yesterday's release showed that there has been a shift toward expectations that rates will rise more rapidly than was expected in December. The comparison of the dot plots out to the end of 2016 is shown below.

When asked about the implication of the dot plots at the press briefing, Yellen said “I think that one should not look to the dot plot so to speak as the primary way in which the committee wants to or is speaking about policy to the public at large … I would simply warn you that these dots are going to move up and down over time, a little bit this way or that,” she added.

Yellen faced a tough task in having to explain the change in the forward guidance, the change in the dot plots and the notion that nothing had changed in the Committee's intentions. Market movements reflected not so much a change in the Fed's view as an increase in the market's uncertainty about how to interpret the Fed's statements.

The Fallout

Stephen Poloz' limits to growth speech and Janet Yellen's comment equating a considerable time to about six months, when taken together, give the appearance of growing divergence in Canadian and US monetary policy thinking. The somewhat loose comments made by both central bank governors might be considered rookie mistakes. It is unlikely that it was the intention of either Governor to have as big a market impact with their statements as they received. However, in a world where policy rates have been held at unusually low levels for an extended period, and where asset prices and exchange rates have become highly sensitive to even the slightest shift in central bank language, it is not surprising that the two new Governors rattled the markets with their comments.

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