In its most recent MPR, the Bank of Canada produced a growth forecast for 2010 that seems rather optimistic compared to some private sector forecasts:
Bank of Canada 3% Merrill Lynch 2.7% Bank of Nova Scotia 2.5% Royal Bank of Canada 2.5% Shock Minus Control 2.5% Bank of Montreal 1.8% CIBC 1.5% Toronto-Dominion Bank 1.4%
One probable reason for the variance between my forecast and the Bank’s is the Bank's assumption of an 87 cent US/CAD exchange rate versus my model range of 87 to 95 cents. Indeed, I can account for quite a bit of the variance between my own forecast and the Bank's simply by tweaking the exchange rate assumption.
Of course, there any number or assumptions that could be driving this difference, particularly within a complex model such as TOTEM, the Bank’s primary forecasting model. However, the low exchange rate assumption does seem to be a pretty important one.
The Fed has announced a massive quantitative easing program directed at purchases of mortgage backed securities and long-term treasuries - following the liquidity trap/deflation playbook discussed in this post.
So what is quantitative easing? Here are some great links that should tell you all you ever wanted to know. Enjoy!
Maybe. Here is the story (it’s a long and extremely wonkish story, but hang in) – Start with the Euler condition and the Fisher equation from a standard money-in-utility (MIU) model:
Pt(1+ ίt)/Pt+1 = uc,t/βuc,t+1(1)
Which can be rewrittenas:
1+ ίt = (Pt+1/Pt) z(2)
Where z is assumed constant and summarizes the real factors that influence the real interest rate, r*. Taking logs of both sides,
ίt = pit+1 + ln(z)(3)
Further assume that the central bank follows a simple Taylor rule of the form:
ίt = r* + pi* + δ(pit – pi*) (4)
Where ίt is the nominal rate of interest and r* is the natural rate of interest. Combining (3) and (4) gives an equilibrium process for inflation that looks like:
pit+1 = pi* + δ(pit – pi*)
Finally, assume the central bank follows the so called “Taylor Principle” that the central bank reaction function should respond disproportionately, or more than one for one, to changes in inflation. Therefore, in the above equilibrium process, δ>1. Graphically, the dynamics of this equilibrium process looks like this:
Notice that the policy rule is bounded at the rate of deflation consistent with the zero nominal bound for interest rates. To see how this type of rule could lead to a liquidity trap equilibrium, observe that if inflation starts out below pi*, the stationary “good equilibrium” where inflation is equal to its target level, the central bank will cut the nominal rate in order to stimulate the economy. Under the above rule, inflation will decline leading to another rate cut, generating further expectations of lower inflation, and so on until it reaches the stable but deflationary equilibrium, pi**.
At this point you should be thinking – wait a minute, shouldn’t interest rate cuts lead to higher inflation expectations? Under normal conditions yes, but think of the above model in the present context in which inflationary expectations may have become detached from the 2% anchor and in which the economy is performing well below potential – it may be the case that rate cuts, particularly near the zero lower bound, will feed deflationary expectations. Moreover, since the only stable good equilibrium is at pi*, and because the inflation process is forward looking, the only way to get out of the deflationary equilibrium is to get expectations to jump to the good equilibrium at pi*.
I discussed how policy-makers might engineer such a jump in a previous post.
Views expresed here are mine alone and should not be attributed to my employer or colleagues. I make no assurance of the accuracy or validity of any of the information on this blog and will not be held liable for errors, omissions, or damages arising from use of information presented on this blog.
