Economy’s Goldilocks moment
Bank of Canada treads carefully on interest rate
Once upon a time, there was a little economy that wasn’t too hot and wasn’t too cold. It was just right. After running for a while at breakneck speed, its growth had slowed down to a more sustainable lope, but it wasn’t so slow as to worry anyone.
Meanwhile, even though the pot of GDP gold was expanding nicely, people weren’t paying much more for anything than they were before, which is to say that inflation was low.
Looking down from above, the central bank, which presided over such things, saw that it was good. And so there was no need to tinker with interest rates. Or, as it said in the inspiring language of central bankers, “the current stance of monetary policy remains appropriate.”
This is no fairy tale, obviously, and those inspirational words were not penned by the Brothers Grimm, but by the Bank of Canada, which on Wednesday kept its key policy rate at one per cent. That surprised almost no one, given that the current state of the economy — not too hot, not too cold — suggests we’re basking in a Goldilocks moment, where the balance of supply and demand has hit “the sweet spot,” as Bank of Canada Governor Stephen Poloz put it in October.
Well, if the Canadian economy is indeed a Goldilocks story, it might be wise to remember that, like most fairy tales, it’s a cautionary one. Besides warning against breaking- and- entering as a pastime and antagonizing bears, it is also about the perils of being too picky. Goldilocks was annoyingly difficult to please — and the Goldilocks moment for the Canadian economy might be very difficult to maintain.
No doubt the Bank of Canada realizes that, as it hedged its no-move decision last week with some cautionary tones. It expects GDP growth to moderate even further in coming quarters, and while employment has been surprisingly strong, it also noted continuing slack in the labour market. Meanwhile, the bank sees “considerable uncertainty” in its global outlook, citing trade policies and geopolitical developments. Left unmentioned, though no doubt on Poloz’s mind, are two other factors that the bank had previously cited as the most important vulnerabilities to Canada’s financial system: Canadians’ high levels of household debt, and continuing overheated housing markets, at least in Toronto and Vancouver.
From a policy perspective, those risks and vulnerabilities force the central bank into a delicate balancing act. As much as it might like to navigate toward interest rate normalization to prevent the economic porridge from getting too hot, it can’t do that so quickly that the porridge gets too cold.
The simple approach, all else remaining equal, is to stand pat on rates as it did on Wednesday. But all else is not likely to remain equal. Although the bank has hiked by 50 basis points already this year, its policy- setting rate remains well below anything approaching neutrality. At 1.4 per cent in October, inflation isn’t close to the two- per- cent target, but that could change quickly; if wage pressure (perhaps driven by minimum wage hikes in Ontario) intensifies, the bank could find itself behind the curve. Porridge too hot.
Meanwhile, with rates still low, household debt in Canada — which, according to the Organization for Economic Co- operation and Development, is the only developed economy in the world with a householddebt- to- GDP ratio higher than 100 per cent — could continue to grow. If you don’t think that’s a dangerous situation, there’s history: The last time there was a vaunted Goldilocks economy was 2003-2007 in the U. S., when inflation was contained and GDP growth was strong. That didn’t end so well.
So why not j ust raise rates? Well, despite its notes of caution, the bank is widely expected to do just that, and probably repeatedly, next year. But it will have to hike very carefully. Turn down the heat on the economy too much or too quickly, and the porridge could easily get too cold. Business investment is already slowing, and higher rates would support the already- strong dollar, hurting exports. Even worse, the withdrawal of rate stimulus might not just shrink the household debt bubble, but burst it. How far can the bank raise rates before Canadian consumers find they can’t pay their bills or sustain their home equity lines of credit? If the bears lose their highly leveraged house, Goldilocks won’t even have a place to break into.
That’s just the internal issue. Trade policy uncertainty is another vulnerability. There’s an American troll sitting under the Ambassador Bridge, grumbling that he’s been getting a raw deal from all the oats and chairs and mattresses going back and forth across the Canada-U. S. border. If President Donald Trump makes good on his continuing threats to pull out of NAFTA ( now under difficult renegotiation), Canadian exports, imports and GDP growth will all take a hit, even as consumer prices are likely to soar. If the Bank of Canada tightens just as NAFTA disintegrates, watch out; on the other hand, a one- per- cent policy rate doesn’t leave the bank much room to ease if NAFTA falls.
Of course, the story doesn’t have to end badly, and the Bank of Canada could well pull off this balancing act, however challenging. Goldilocks, after all, didn’t end up with much more than a scare when the bears came home and she hopped out the window. Pessimists, though, might recall an earlier and more grisly version of the tale, in which “Goldilocks” — a foul- hearted crone, in this telling — ends up being burned, then drowned, and then impaled on the steeple of St. Paul’s Cathedral by the three bears, who are anything but cuddly.
The point is, Goldilocks moments tend not to last. The only real question is how they end.