What comes after the ELB?

In its recent policy statement, the Bank of Canada took the unprecedented step of declaring a conditional commitment to keeping the overnight rate at an effective lower bound (ELB) of 25bps until June 2010. Moreover, In its accompanying Monetary Policy Report, the Bank has forecast that inflation will not return to target until the third quarter of 2011. This got me thinking – what do these two statements imply about the Bank’s strategy in moving the overnight rate off of the ELB and to some “neutral” level?

The path of short interest rates that is consistent with 2% inflation by Q3 2011 would be readily available to policymakers from running the Bank’s medium term projection model, ToTEM. I tried to elicit some indication of future policy from Pierre Duguay at a recent presentation but he quite rightly only waved his hands.

Fortunately, we don’t need to extract such information from reticent Bank of Canada Governors when we can employ a Taylor Rule. Plugging the Bank’s most recent forecast for growth and inflation into a simple Taylor Rule provides the following (Click to Enlarge):

The rule suggest that monetary policy consistent with 2% inflation would have interest rates rise 225 basis points between June 2010 and September 2011. It would be interesting to observe if there is any action in bond markets based on the BoC outlook. I'm no expert in the matter but if this analysis is reasonably accurate, there should be money to be made shorting the front end of the government yield curve next summer.

Carney decides to cut

Well - not a total surprise that Carney and Co. went with a 25bps cut, though I still don't believe it will have any material effect. The real surprise was the commitment to keep the overnight rate at 25bps for the foreseeable future as well as no mention of quantitative easing in the BoC statement. Interestingly, the Bank has also downgraded its previously optimistic forecast from -1.2% in 2009 to -3% (my own current forecast is for -3.2%) and suggests that inflation will not return to target until midway through 2010 (my own model would suggest otherwise but I'm not entirely sold on my inflation equations and will be revisiting them once I have an afternoon free).

More to come when the Bank releases its Monetary Policy Update on Thursday.

BoC Announcement Tomorrow

I think that I am with the majority of economists when I say that I do not believe that cutting rates tomorrow will do any good. Bank lending tightness is still at a record high even after over a year of monetary easing. Clearly something different needs to be tried in order to alleviate constraints on lending and that something appears to be quantitative easing.

How should the BoC go about implementing a quantitative easing program? I'll outsource that part to Pimco's Ed Devlin.

Financial Linkages and the Real Economy

The most recent Bank of Canada's senior loan officer survey showed that despite the historic level of monetary stimulus, bank lending in Canada is still remarkably tight. The implications for New Keynesian type forecasting models that rely on Taylor-type reaction functions is that the current disconnect between monetary policy and private sector borrowing conditions will be missed However, recent research by economists at the IMF offers a simple way to incorporate financial linkages loan officer survey data.

I am planning to incorporate these financial linkages into my larger model, but for now I thought it would be interesting to run a quick and dirty VAR. The figure below shows the impulse response of Canadian real GDP growth to a one standard deviation lending tightness shock.


This simple VAR analysis reveals that a one standard deviation shock to the BoC senior loan officer index (about 15 points) translates to a -0.35% decline in real GDP growth after four quarters. This would indicate that current lending conditions (an index reading of about 60) will have persistent negative effect on the economy and further highlights the importance of addressing the liquidity needs of the Canadian banking system.

Forecast update

I've updated the Canadian quarterly forecast ( see link in upper right corner) to reflect the weakness of incoming data. I've jumped on board with David Wolf and Kevin Page, forecasting a contraction in Q1 of 8.2%. I also expect Q2 to be significantly worse at -3.8% before the economy begins a recovery sometime in Q3-Q4 as a result of fiscal and monetary stimulus. This forecast is considerably more bearish than the Bay Street consensus (a good thing?).

Home Construction Rebounds

...at least that was the headline in the Globe and Mail. Now, I don't know who writes headlines, but this is a great example of a misleading one and I'll go ahead and blame the writer - Heather Scoffield. According to Heather, housing starts increased by a "mind boggling" 13.7% in March. She then goes on to enumerate a number of reasons why the uptick in starts may not signal anything significant, which begs the question why the headline was so exuberant.

What didn't make the article? How about the fact that year-over-year March housing starts - a better measure than the highly volatile month-over-month - were down 36% and quarter-over-quarter starts have fallen 20%. Not exactly a rebound.

A Bridge to Where?

Canadian economic forecasters have recently been drastically lowering their expectations for Q1 GDP from simply a very bad quarter, say around -4% to -5%, to expecting one of the worst quarters in Canadian history. So what gives? Is incoming data really that bad? How can one reconcile current data with quarterly forecasts?

Well, it turns out that there is a fair amount of literature on updating quarterly forecasts with monthly information. One technique that caught my eye (because of its simplicity) is the construction of a so-called “bridge” equation. A bridge equation is basically a simple regression of monthly economic variables, aggregated to quarterly values and then used to forecast quarterly GDP. An example of such an equation can be found in this Bank of Canada working paper.

The model in the BoC paper includes the consumer confidence index, hours worked, retail sales, housing starts, 3-quarter lagged Canadian GDP and US industrial production as explanatory variables. Based on the most recent data for those variables, the bridge model predicts Q1 real GDP growth of -8.3%. This compares with a quarterly model prediction of -4.4%.

So, using the bridging equation we end up at the same bad place arrived at by Bay Street and others– a really really really bad Q1.

50 posts-hmm...

Having just hit 50 posts, I thought I would share some reflections on blogging:

Things I enjoy about blogging:

1) I have been out of grad school for 3 years, and I have found blogging to be a very useful way to organize thoughts and to motivate myself to keep learning. Without blogging I don't think I would have ever have had the motivation to put in the time and effort to construct a quarterly forecast model, something I've always been interested in but never found the time for.

2) Feedback - I love getting comments, not only because blogging (and maybe Canadian econoblogging in particular) can sometimes feel like an echo chamber but because they help me to refine or revise my thinking. Enormously helpful.

3) I like having a record of my thoughts, even if they don't always make sense.

Things I don't enjoy:

1) Sometimes I simply don't have anything to say, for extended periods of time. I am in constant amazement of people like Nick Rowe, Mark Thoma, Menzie Chinn/James Hamilton and others that put up insightful and detailed posts on a daily basis.

2) Blogging can be time consuming - I have a wife and two kids (1 and 3), and a demanding full time job and finding time/energy to write is not always easy.

3) Working hard on a post that I think is really interesting and then seeing a big doughnut in the comments section. A little deflating at times - then again, I probably only comment on 1/100 of the blog posts I read, so I'm not sure why anyone else would be any different.

In all, after 50 posts I'm reasonably happy with my contribution to the small world of Canadian economics blogging. My next project for the site is to build a US model and post US forecasts, perhaps as a summer project.

Thanks to all who have been reading - on to the next 50!