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Bank of Canada moves to hit the ball

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The release of today's Monetary Policy Report from the Bank of Canada follows yesterday's announcement of no change in interest rates, the latest in a long series. It reminds me of an English County cricket match in which a batsman is politely applauded -- "very well not played, sir!" -- for doing absolutely nothing other than watch a potentially dangerous pitch fly by slightly wide of the wicket.

Of course, Carney did more than nothing by not so subtly signalling -- through elimination of the word "eventually" with reference to removal of monetary stimulus -- that he is going to probably raise rates fairly soon, unless, of course, things change. That gesture alone was sufficient to significantly drive up the exchange rate of the Canadian against the U.S. dollar.

What I find suspect is the Bank's view that the output gap will disappear in less than a year, by mid 2012. While this simply restates the view taken in the previous report, the fact that we are supposedly closing in on capacity as expected seems to be the reason why interest rate hikes may be coming.

The Report is, as always, quite nuanced. But the overall tone is unduly optimistic given some key changes in the global economy in recent weeks.

Not only is the U.S. economy slowing quicker than thought, the end of the last stimulus package seems set to be succeeded by even greater than foreseen public sector austerity as the Tea Party drives the political agenda. And there now seems little prospect of further quantitative easing, which could mean an increase in long-term U.S. interest rates moving forward.

Meanwhile, as the Report notes, the EU recovery overall has been fairly robust. But the stage now seems set for a major shift to fiscal austerity and to higher interest rates in Spain and Italy as the sovereign debt crisis intensifies and moves from the periphery to the centre.

Here in Canada, the Bank expects net exports to grow, even in the face of a very weak U.S. economy and a very high Canadian dollar. And they expect fairly strong business investment growth to continue despite the U.S. slowdown and the high dollar. That boils down to a pretty serious bet that high commodity prices and resource exports can carry the whole economy.

The Bank is not blind to the fact that the labour market remains weak. But it is worth underlining just how much slack there is in the job market today compared to the period before the crisis. Compared to October, 2008, the unemployment rate is up (from 6.1% to 7.4%), the employment rate is down (from 63.5% to 62.0%) and the proportion of both part-time workers and involuntary part-timers has risen. The "real' unemployment rate last month -- which counts labour force dropouts and involuntary part-timers -- was 10.7%. I know that the output gap is about more than the job market, but that doesn't sound like closing in on capacity to me.

Some will cite the threat of inflation as a reason to remove monetary stimulus. But the Report makes it clear that core inflation is pretty much in line with the 2% target, and that the factors feeding into a higher rate of increase of the CPI are transitory.

Putting it all together, the Bank seems unduly optimistic about where we are headed, and overly anxious to hit the ball.

This article was first posted on The Progressive Economics Forum.

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