The recession is over!!...now about that recovery...

Canada has had three severe recessions in the past 30 years; one in 1981, again in 1990 and the most recent one that began in the last quarter of 2008.

The 1981 recession was a classic “V” shaped recession and lasted roughly five quarters. It was also the second part of a double-dip recession, following a brief contraction in 1980. The recession of 1990 was a steep, extremely painful and protracted “U/L” shaped recession, and was followed by a very weak recovery.

The Bank of Canada made some noise this past week after the release of its latest Monetary Policy Report (MPR) predicting an end to the recession in Q3 of this year. If the Bank’s forecast is correct (remember that it is a forecast, not an official statistical release) then the 2008 recession would go into the books as the shortest of the past three Canadian recessions.

The following figure illustrates the path of the Canadian economy 12 quarters after the business cycle peak prior to the recession for 1981 and 1990 along with the recent Bank of Canada forecast.



So where does the BoC expect the recovery to come from? Three places – Personal Consumption Expenditures, Government and Inventories. See below from the July MPR

I have my doubts that PCE will really be that strong coming out of this recession. THe unemployment rate is liklely to approach 10% and household saving is rising in response to massive wealth destruction from falling equity and home prices over the past year. However, indicators such as retail sales and consumer confidence do seem to be improving, so perhaps the Bank is right.

The real difference maker in the expected recovery from the 2008 recession, compared with past recessions, is the fiscal policy response of the Canadian Government. Government spending in the year following the end of the 1981 recession contributed just 0.3% to real GDP growth and only 0.2% to real GDP growth in the year following the end of the 1990 recession. In contrast, the BoC estimates that Government spending will add 1.3% to growth in 2010.

Given that inventory rebuild is estimated by the Bank to add 1% to growth in 2010 and you have 2.3% of the 3% growth forecast estimated to come from temporary sources that may not do much for job creation. Add an uncertain outlook for the Canadian housing and non-residential construction sector and it would seem like we have a recipe for a jobless recovery in 2010. But at least the recession is over...right?

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Baby Induced Blogging Hiatus

Mrs. Shock Minus Control gave birth to our third boy this morning - blogging will be light for a while.

The Canadian Dollar Response to an Oil Shock

In a 2006 Bank of Canada working paper, (highly recommended) Issa, Lafrance and Murray showed that, sometime in the 1990s, a structural break occurred in the relationship between the Canadian dollar and energy prices. Whereas prior econometric estimation (see Amano and van Norden 1995) showed that higher energy prices lead to a depreciation in the Canadian dollar, the authors showed that this relationship no longer held and that in fact rising energy prices tend to drive the loonie higher.

This finding shouldn’t be a surprise to even casual observers of commodity and currency markets. The loonie has followed oil in virtual lockstep for many years, hitting 1.10 to the US dollar as oil rocketed past $100/barrel.

To me, it is not immediatley clear why rising oil prices should impact the loonie. Oil is traded in US dollars and so higher Canadian oil exports shouldn't impact the Canadian dollar since the sale of oil does not create additional demand for Canadian currency. However, higher oil prices do create demand for Canadian dollars for the purpose of FDI – international oil companies developing projects in the oil sands do need to pay for assets, labour, etc in local currency. The oil-price break-even rate on these projects is high and so investment is driven by price. Therefore, oil impacts the loonie through the capital account, rather than the current account. (at least that is my take, if I’m wrong, please feel free to tell me so).

I use a version of the Issa, Lafrance, Murray model that, as shown in the dynamic simulation below, tends to track the Canadian dollar fairly closely.

Dynamic Simulation of CAD/US Exchange Rate, 2004-2008

If we are conviced that oil price are a significant driver of the Canadian dollar, then it may be interesting to ask how a future oil price shock will impact the loonie vs. the greenback.
The graph below sets out the baseline scenario for oil prices, based on EIA forecasts, and a somewhat arbitrary path for a hypothetical oil shock that would have the USD price of oil rise to $130 by the third quarter of 2010.

If the future path of oil prices looks more like the green line than the EIA forecast above, then, from the model, we should expect to see Canadian dollar back to parity early next year.


Rising oil prices may get the loonie near parity, even without a steep run-up in prices, particularly if accompanied by weakness in the US dollar. But if oil really starts to run, I think it is very likely that the loonie will approach, or possibly surpass, its previous highs.

Back from vacation...

...blogging to resume shortly.

Whats going on with the yield curve part 2: Does a steepening of slope imply growth?

I'm having a hard time with this one. The model I use for forecasting real GDP growth relies on changes in the slope of the yield curve as the mechanism by which monetary policy works. As discussed previously, the slope of the Government yield curve (10yr - 3month) has steepened dramatically in the past month. This steepening is often interpreted as a positive signal that market participants expect short-term rates to rise in the future as growth and eventually inflation pick-up. What I am having a difficult time with is whether this is the right way to interpret what is currently happening in the Canadian economy. The Bank of Canada is certainly not going to be raising rates any time soon, and research by the IMF shows that recoveries from recessions caused by financial crises tend to be slow.

The forecast implications are significant. Ignoring the signal from the yield curve implies a less robust recovery while accepting it provides a recovery akin to what the Bank of Canada forecast in its last MPR. The figure below illustrates the incremental growth implied by the yield curve shock (versus a control baseline of ignoring the signal, eg, running a simulation in which no steepening occurred

I'm leaning towards interpreting the movement in the yield curve as simply the normalization of inflation expectations and the impact of the "flight from quality" as investors regain confidence. Anyone want to try to convince me otherwise?

What's going on with the yield curve?

Milton Friedman famously proclaimed that “inflation is always and everywhere a monetary phenomenon”, implying that inflation is inextricably linked to the money supply. This thinking has lead some analysts and others to voice heightened fear that monetary stimulus provided by the Bank of Canada, and the Federal Reserve in the United States, can only lead to a resurgence in inflation.

Proponents of this view point to the recent increase in the slope of the government yield curve as a clear signal that purchasers of government treasuries, fearful of the impact of massive monetary and fiscal stimulus, are ratcheting up their inflation expectations and demanding a higher yield on long-term debt. Still others view the steepening yield curve as a positive signal of expected future growth and the end of the recession. So which is it?
Looking at inflation expectations derived from Canadian real-return bonds, it is pretty difficult to conclude that Canadians, or buyers of Canadian debt, expect runaway inflation on the horizon. Inflation expectations seem to have ticked up recently, but I think only because a Great Depression II induced deflationary spiral seems to be off the table. Moreover, expectations remain firmly anchored in the BoC comfort range

It is also hard to conceive of a scenario in which inflation could get out of control while the economy is operating so far below its potential.


My own opinion is that the increase in the slope of the yield curve is a function of the following factors (in no particular order):

1) Flight from quality – investors getting out of treasuries and back into riskier assets

2) Normalized inflation expectations – fears of a deflationary spiral seems to have been successfully beaten back by the Bank of Canada

3) Expected Government borrowing due to larger than anticipated fiscal deficits

4) Expectations that the worst of the recession is over and the economy will return to positive growth soon.