WHY THE FEDERAL RESERVE’S ACTIONS MATTER MORE TO CANADA THAN OUR CENTRAL BANK’S.
COVID response in U.S. dwarfs Canadian moves
Canada has far outdone the average country in the Organisation for Economic Co- operation and Development when it comes to both the fiscal and monetary policy measures to combat the economic pain from COVID-19. It goes without saying that fiscal policy, with or without the multiplier effects, hits the economy right away and the force with which Ottawa unleashed its budgetary resources without having to bargain with opposing parties as is the case in the United States helps explain why the local economy has performed so well.
The medication has certainly helped a lot, and now Ottawa is using the crisis as a way to expand its tentacles even more, with the recent throne speech leaving no stone unturned, and with more than just tacit approval from the socialist NDP.
The argument is that debt has no limits so long as interest rates remain at the floor and inflation never shows up again. Of course, this was the same line of reasoning used in the late 1960s and early 1970s, which then blazed the trail for Canada’s fiscal misery for decades to come ( classic case of like father, like son).
The Bank of Canada has also come under scrutiny of late for probing the outer limits of monetary policy intervention. Then again, it isn’t alone: every central bank is pretty well doing the same thing and we now have the money market in the United Kingdom pricing in negative interest rates by the Bank of England, and word is that the Reserve Bank of Australia is set to embark on rounds of quantitative easing (QE) in the near future.
As we assess the effectiveness of what the Bank of Canada is doing, it is key to disentangle the global effects, and keep in mind that what is most important for the Canadian economy and Canadian markets is what the U.S. Fed is doing.
Recall that all we had to do was wait for the fruits to bear back in 2009 when the Fed embarked on QE and the benefits flowed north of the border — back then, the BOC didn’t even have to lift a finger ... and that is because Canada’s capital markets are really priced off U. S. capital markets.
Much of what happens in the Canadian economy and financial markets is largely influenced by events south of the border. Be that as it may, the Bank of Canada, back on March 27, announced it was cutting the policy rate to the effective floor of 25 basis points and moving to a strategy it had previously avoided, which was the onset of an asset purchase program (that is, QE).
Since that time, the central bank’s balance sheet has expanded 320 per cent ( or $ 413 billion). This is an astonishing figure for a nation whose GDP is expected to be barely higher than $2 trillion this year. Of these new BOC holdings, the vast majority are the $ 227 billion of Government of Canada bonds and T- bills and $ 165 billion of securities purchased under resale agreements.
What did the markets and the economy get in return for all this intervention? A regression analysis controlling for policy rates and inflation expectations suggests the cumulative effect on the 10- year Government of Canada bond yield was a maximum reduction of roughly 30 basis points. For reference, the 10- year yield dropped from 1.39 per cent to 0.58 per cent ( 50 basis points of which wasn’t a result of QE) from February to September.
The good news for the levered- up Canadian consumer is that the rate relief ultimately flowed through to mortgages, albeit in a minor way as it translated to roughly a 15-basis point cut on the benchmark rate. That’s all, folks.
Unfortunately for the BOC, the marginal benefits of the asset purchase program appear to stop there, and the simple reason is that much of what happens north of the 49th parallel depends on what decisions are made south of it.
For instance, the wealth effects hoped for through QE measures should, in part, result in Canadian equity prices rising. Indeed, the Canadian stock market has rallied from the lows, but 60 per cent of that run- up reflected the surge in U.S. equities (global, too). Only 22 per cent of the bull run here was statistically due to the direct actions by the BOC.
Our model shows the impact of the Canadian QE adventure is dwarfed by the effects of the U. S. interventions, and becomes insignificant. Maybe the BOC should have done what it did in 2009 and just stood pat.
The same is true for credit spreads, which the BOC is actively supporting. But here again, we estimate that 42 basis points of the 108- basis point spread tightening from the widest levels during the panic is owed to the bank’s actions. The rest just naturally flowed from what the Fed was doing.
Maybe it’s best to let Fed chair Jay Powell and his merry men and women do the job for us. Then again, it stands to reason that someone here at home wants to have the credit.
Similar stories hold on the macroeconomic front. The detonation in GDP in the second quarter came as provinces locked down to stop the spread of COVID-19. Our analysis shows that the flow- through from the lower rates on to GDP is going to be marginal, at best. From the QE aspect, and taking into account that monetary policy affects the real economy with lags that can be long and variable, we anticipate the boost to GDP growth to only be about 0.6 per cent at an annual rate — not a whole lot.
The indirect impact on the Fed’s easing program on the Canadian economy ( by stimulating domestic demand in the U. S. and filtering into Canadian exports, production and employment) amounted to a boost of 2.4 per cent ( annualized).
Meanwhile, the effect of cutting the overnight rate by 150 basis points has contributed 2.7 per cent ( annualized) to Canadian GDP, slightly larger than the effects of the U. S. actions. Rates are more important than QE by a factor of nearly five — something to keep in mind since we are at the floor on rates ( we doubt BOC Governor Tiff Macklem will go the negative- rates route).
The narrative on inflation is much the same. Controlling for global inflation by using the U. S. as a proxy, the jump- off in the money supply contributed roughly 0.5 per cent ( annualized) to headline inflation, though this pales next to the actual deflationary influence from the massive output gap that has opened up in Canada and will take years to close.
The bottom line is Canada is a small open economy. As such, many forces that determine its fate are far beyond its control when it comes to the economy and the financial markets. Actions such as asset purchases did have some impact on borrowing rates, credit spreads, the stock market, inflation and economic growth, but before the BOC or anyone else takes the time to accept the credit, the far bigger effects came from what happened in the U.S.
In other words, the big rebound in asset prices that we have seen since the lows in the market is more explainable by the direct and indirect actions taken by the Fed. Sorry Tiff, but Jay has the bigger gun.