Is there a normal to return to?

Fed hikes again, BoC seemingly not far behind

In raising its target interest rate by 25 basis points on Wednesday, the U. S. Federal Reserve hit something of a milestone: it has now implemented a full percentage point of increases since December 2015, when it hiked for the first time since the global recession. But like the Dow at 2,000 or the 100day mark in presidencies, this week’s Fed milestone is relatively meaningless. In central bank policy announcements, as in political leaders and markets, the only thing that really matters is what’s next.

On that front, Canadian investors now have some pretty strong signals, from both the Fed and the Bank of Canada: the “lower for longer” trend is over, even as inflation remains stubbornly below the central banks’ mutual target of two per cent.

We are heading back toward normal. But what exactly does that mean?

Certainly, the Fed is far ahead in the hawk game. It took a hawkish stance on Wednesday, even though only one pillar of the its dual mandate — employment — supports higher rates. The other pillar — inflation — came in at just 1.7 per cent for May, down from 2.3 per cent in January, and the Fed expects personal consumption expenditures, its preferred inflation gauge, to average just 1.6 per cent for the year. Yet the FOMC dot plots, which track committee members’ expectations, point to a 1.4- per- cent rate at the end of the year, suggesting another increase is in the works. Perhaps even more hawkish was the Fed’s decision to begin unwinding its huge US$ 4.5- trillion balance sheet — a hangover from the recession and quantitative easing — later this year, a bond- selling initiative that will effectively reduce the money supply.

Meanwhile, in Canada, job creation is strong and unemployment low, but inflation is trending well off the Bank of Canada’s two-per-cent target. And yet, earlier this week, Governor Stephen Poloz said in a media interview that strong GDP growth — 3.7 per cent in the first quarter — suggests “the interest rate cuts we did two years ago have done their job, and that’s important to us.” Markets widely interpreted Poloz’s comments as a sign that rate hikes are in the offing, and they now price in a better than 70- per- cent chance of one by December.

Do Poloz and Fed chair Janet Yellen just not care about inflation targets? One rationale for their seeming nonchalance is that they expect inflation to catch up. After all, higher employment should create wage pressure, which should create inflation. Or at least it’s supposed to work that way. ( Note that it really hasn’t through this business cycle.) On the other hand, maybe central bankers have bigger things to worry about than under- target inflation.

Maybe the trouble is bubbles. Even though the Fed has raised rates, asset prices keep going up, especially in financial markets. Equities remain at or near all- time highs — which might be justified despite rising rates, given the rebound in corporate earnings. The greater danger might lie in fixedincome. Treasury yields last week hit lows not seen since before the election of Donald Trump, and the Fed’s rate in- crease did not move them up on Wednesday, as one would expect. In fact, they declined — in the case of 10- year Treasuries, by more than nine basis points.

The dynamics of lower bond yields in a rising rate environment are complex. Fixed- i ncome i nvestors might be signalling skepticism over the Fed’s rate-hiking path, particularly with inflation so low. Yet market realities are in play, too: other safe- haven bonds in Japan and Europe, where central banks maintain negative interest rates and bond-buying programs, offer no yield at all. If you must hold “risk- free” bonds, there aren’t many alternatives to the U.S.

Meanwhile, ultra- l ow yields in sovereigns have pushed down yields in riskier assets. Corporates and high-yields now offer meagre premiums for added risk: the Bank of America Merrill Lynch High Yield Option-Adjusted Spreads index, which measures the yield of below-investment-grade bonds over the Treasury curve, has declined by more than 340 basis points in the past year, and now sits at less than 3.75 per cent. Either that’s a sign of the U. S. economy’s strength or a severe mispricing of risk; either way, the Fed has little choice but to try and restore “normalcy.” The question is how far it is willing to go.

The Canadian bubbles are more immediately recognizable: housing prices have gone through the roof, along with household debt. The Bank of Canada has been reluctant to step in with higher rates, however, because business investment and exports have been so weak, thanks in large part to the oil- price crash. Now, the bank seems to be signalling that oil prices are no longer an issue. “The adjustment to lower oil prices is now largely behind us,” Carolyn Wilkins, the Bank’s deputy governor, said last week. That suggests the path toward rate normalization has been cleared.

But is it? The hot housing markets have fuelled investment, construction and renovations — and, with exports still weak, they comprise a huge factor in Canada’s strong GDP growth. Another factor is oil and gas investment, which might have much more to do with the fact that oil prices have rebounded from their 2016 lows than with easy monetary policy. But the rebound is hardly a slam dunk. If it reverses seriously (as would happen, say, if OPEC abandons its production limits next spring), then the Canadian economy would find itself right back where it was in early 2014, only with a much more inflated housing bubble hobbling central bank action.

So can the Fed and Bank of Canada succeed in their efforts to get things back to normal? Maybe. Or maybe they will find that, after a decade of super-easy money, “normal” just ain’t what it used to be.