Yesterday Bank of Canada Governor Stephen Poloz gave a speech titled “The Legacy of the Financial Crisis: What we know, and what we don’t.” It is probably the most dovish speech I have ever heard a Bank of Canada Governor make. Poloz argues that although the global recovery since the 2008 credit crisis has been disappointing, the alternative of trying to wade through without massive Central Bank stimulus would have been much worse.
We will never know how bad things would have been without that aggressive, coordinated policy response. But as a student of economic history, I can say that all the ingredients of a second Great Depression were present. We’ve managed to avoid that extreme scenario, but the damage wrought by the Great Recession has been brutal nonetheless. By the end of last year, the loss to global output from the crisis was roughly US$10 trillion, which is close to 15 per cent of global GDP. Today, there are over 60 million fewer jobs around the world than had the crisis not occurred.
To a large extent, this is just typical Central Banker speak. But Poloz goes on to worry that we have forgotten how bad things really were (are).
Still, memories of that near-disaster are fading, and today people are wondering why our policies have so far failed to foster a true global recovery, one that is natural and self-sustaining.
From there, Poloz analyzes why a full fledged economic recovery is so elusive. He acknowledges that the reduction of leverage and the shrinking government fiscal situation is weighing heavily on the economy. But he then highlights that a lack of confidence is real driver to the recent economic underperformance.
The third, and probably the most important, headwind is lingering uncertainty about the future, whether from geopolitical developments, market volatility or just the trauma that companies have been through. Some people look at companies with strong balance sheets and wonder why they are not investing. Some have suggested that we have too much risk taking in financial markets, but not enough risk taking in the real economy.
But that’s not what we’re hearing from the companies we talk to here in Canada. In this uncertain economic climate, companies actually feel like they are taking a lot of risk. And until the recovery is more certain, especially in export demand, for many, it is too risky to expand their businesses.
What that seems to mean is that the expected risk-adjusted rate of return on a new investment can appear low to a company, and we can settle into a temporary low-confidence/low-investment equilibrium, even when borrowing costs are extraordinarily low, until uncertainty subsides and confidence returns.
It seems to me that we must allow for the possibility that the combined effects of deleveraging, fiscal normalization and lingering uncertainty will continue to restrain global economic growth for a prolonged period. We are confident that these headwinds will dissipate in time, but in the meantime interest rates will remain lower than in the past in order to work against those forces.
Poloz has fully embraced the idea that interest rates are going to need stay lower for longer. Although he acknowledges the problems with Canada’s continually inflating housing market, his conclusion is that the consequences of stopping that bubble with higher rates don’t outweigh the costs.
He even goes through the exercise of imagining what a more neutral rate would mean to the economy.
Let’s walk through a thought experiment together. What would our world look like today if, instead of keeping interest rates low to stimulate the economy, both Canada and the United States had moved their policy rates back up to neutral at the beginning of 2011? We estimate that the neutral rate of interest today is between 3 and 4 per cent for Canada, and use a similar number for the United States, so our thought experiment is to raise rates to about 3 1/2 per cent in both countries.
Such a move would of course allow those headwinds we talked about earlier to blow us backwards. We estimate that, under this hypothetical scenario the output gap in Canada would have been around 5 1/2 per cent today, instead of around 1 per cent. Unemployment would have been around 2 percentage points higher than it is today, and core inflation would be running somewhere between 0 and 1 per cent.
Most of the impact would be felt in reduced housing construction and renovation and auto production, as these were the sectors that responded to the policies put in place after the crisis. Moreover, these estimates do not capture the range of confidence effects that would permeate the rest of the economy under such a difficult scenario, so the story could even be worse.
From this monetary policy-maker’s perspective, that’s an unattractive alternative. Our primary job is to pursue our 2 per cent inflation target, with a degree of flexibility around the time horizon of its achievement; that flexibility permits the Bank to give due consideration to financial stability risks, provided they do not threaten macroeconomic performance.
He spells it out right there in black and white. Poloz is going to err on being too easy as he views the risks to the downside, not the other way round.
And in case you think he is worried about a weakening Canadian dollar, then you have completely misread him. He is in fact targeting a lower dollar.
But this cycle has not been a typical one. The downturn was deep and has proved to be long lasting. Canada’s export sector not only cut back on production and laid off workers, many companies restructured, many simply disappeared.
Recent Bank of Canada research on exporters sifted through more than 2,000 categories of underperforming, non-energy exports. We found that the value of exports from about a quarter of them has fallen by more than 75 per cent since the year 2000. Had the exports of these products instead risen in line with foreign demand, they would have contributed about $30 billion in additional exports last year. By correlating these findings with media reports, we found that many were affected by factory closures or other restructurings.
Obviously, not all of this can be blamed on the financial crisis and the ensuing downturn, but for companies that were already struggling with competitiveness, the crisis surely accelerated things. The point is, when companies downsize, relocate or close their doors, the effects on the economy are permanent. Those specific lost exports will not recover – something else is more likely to take their place, but that requires that surviving companies expand, or new exporting companies be created. And both such processes are bound to be much slower than in the typical recession/recovery scenario.
Poloz wants a lower CAD. He has basically told you so. When a Central Banker starts tallying up the costs of lost exports, you can only guess one outcome is on his mind.
Yesterday the CAD had a big down day. I suspect that Poloz is quite pleased with this outcome.
Don’t forget that although Canadian overnight rates are low, we actually raised them as the panic from the credit crisis waned.
It would not be out of the realm of possibility that Poloz’s next move would be to lower rates. The world is struggling for growth, with more and more countries desperately trying to capture the few scraps of remaining economic strength through stealth devaluations. To suppose that Canada will be any different would be naive. Especially when you consider that our economy is most exposed to the parts of the global economy that are doing the worst. The recent downturn in commodities, and especially this latest big swoon in the price of oil, is going to weigh heavily. I suspect that Canada is about to experience a big economic downturn that will justify Poloz’s dovish speech.
Although I realize I am late to this trade, I think the CAD could fall a long way. Poloz has just given you the all clear to lean against the Loonie. I am going to establish a short position. I am going to short some CAD outright, but will also have a small long AUDCAD position to try to eliminate some of the overt US dollar exposure portion. And finally, I am going to also buy some long dated puts. I think that FX vol in general is cheap and that it makes sense to express the view through options.