Download A Stable 4% Inflation Could Get Canadians One Half Million More

Cornered
Remarks before the APEBC
Vancouver, November 23, 2016
[email protected]
Department of Economics
ESG UQAM
Ouverture
“There is considerable uncertainty surrounding
potential output estimations”
Lise, Pierre, Ben and Karine
(BoC Discussion Paper 2015-1)
Questions
 Canada’s unemployment rate still hovers around
7% while CPI inflation has averaged 1.6% (without
showing any upward or downward trend) since 2008
 Why has the BoC not kept the policy interest rate to
the floor (as the Federal Reserve has done) so as to
push unemployment down to 6% or under, given that
rising inflation has not been a threat?
 What happened to the BoC’s pledge that inflation
targeting would be symmetric , i.e., that it would be
“equally concerned about inflation rising above or
falling below the 2% target,” so that inflation would
average 2% over time?
Unemployment rate:
now 7% in Canada, 5% in the US
Unemployment rates in Canada and the United States
from January 2008 to October 2016
% 11
Unemployment rates
10
9
Ben
8
Mark
7.0
Steve
7
6
Janet
5
4.9
4
2008
2009
2010
2011
2012
2013
2014
2015
2016
Sources: Statistics Canada; U.S. Bureau of Labour Statistics.
Mean CPI Inflation since 2008:
1.6% in Canada and the US
Year-over-year all-items consumer price inflation rate
in Canada and the United States from January 2008 to Otober 2016
%6
5
4
3
Canada
2
1
0
United States
-1
-2
-3
2008
2009
2010
2011
2012
2013
2014
2015
Sources: Statistics Canada; U.S. Bureau of Labor Statistics.
2016
Policy interest rates:
400-to-500 b.p. plunges
Monetary policy rates in Canada and the United States
from July 2007 to October 2016
%6
5.3
5
4
4.5
3
2
Canada: overnight financing
1
0.25
United States: federal funds
0
2007
2008
2009
2010
2011
2012
2013
2014
2015
Sources: Bank of Canada; U.S. Federal Reserve.
2016
Possible explanations
 Psychology: the BoC may have wanted to show that
it was still in control, and not imprisoned in a "dark
corner" by the zero lower bound (ZLB)
 The conventional measure of potential GDP may
have led the BoC to underestimate the slack in the
economy, to such an extent that the recovery looked
nearly complete in 2011 while unemployment was still
about 7.5%
 CPI inflation was showing no tendency to slow
down further, thus giving the impression that the
economy was indeed operating near its potential
Already recovered in 2011?
Projected no-recession potential GDP, Bank of Canada conventional
potential GDP and actual real GDP, all expressed in per person aged
15 to 64, Canada, 2007-2015 (2007 potential GDP = 100, log scale)
113
Potential and actual real GDP
112
Projected
no-recession
pot GDP
108
108
107
BoC
pot GDP
104
101
100 100
Actual
real GDP
97
96
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
Sources: Statistics Canada; Bank of Canada; calculations PF.
Why is potential underestimated?
 The BoC’s measure of potential is partly based on
a sophisticated moving average of past GDP, which
makes it hard to avoid building a cyclical drop in
output into the estimated potential and thereby
understating the actual shortfall from potential
 A deep recession can have long-lasting scarring
(hysteresis) effects that may temporarily destroy
aggregate supply: skills depreciate, labour force
withdrawals increase, the worker/job matching
process deteriorates, fixed capital formation and
investment in R&D slow down, good firms fail, etc.
Nihil novi sub sole
 In 1997, the BoC’s measure of potential GDP indicated
that the recovery was complete even as unemployment
rate was still hanging around 9%
 This 9% was 3 p.p. higher than the unemployment
rate of 6% in 2007, which was accompanied by a core
CPI inflation rate of 1.5%
 Given an Okun’s coefficient of 2, potential may have
been underestimated by as much as 6 p.p. then
 Until 2006, the BoC’s estimate of potential GDP was
pictured with a large shaded confidence interval of 2%
How much stimulus is possible?
 Call r-star the neutral real interest rate at which the
economy operates at full capacity with stable inflation
 To be stimulative , the BoC must set its nominal
policy interest rate (r-pol) below the corresponding
neutral nominal interest rate:
r-pol < r-star + i-ex
 However, the BoC is constrained from below by some
lower bound for its r-pol (maybe 0% or a bit lower):
r-low < r-pol
 Stimulative r-pol is limited to an interval of length:
r-star + i-ex – r-low
The room for stimulus has shrunk
(percentages)
A Neutral real policy
interest rate (r-star)
B Market-expected
inflation rate (i-ex)
C Effective lower bound
for policy rate (r-low)
A+B-C = Maximum room
for stimulus
1983-90
Laubach
&Williams
3.25
2011-16
BoC
IMF
1.25
0
4.5
1.6
1.6
-0.5
-0.5
-0.5
8.25
3.35
2.10
Sources: Laubach and Williams (2003, 2015); Obstfeld et al. (2016);
Mendes (2014); Poloz (2016); Statistics Canada; calculations PF.
Cornered
Difference between the actual and neutral policy rates as an
indicator of tight or stimulative monetary policy, and room
available to the Bank of Canada for manoeuvre, 1958-2016
p.p.
8
Actual rate minus neutral rate
6
4
Tight
2
0
-210 b.p.
-2
-4
Stimulative
-6
-8
60
65
70
75
80
85
90
95
00
05
10
15
Sources: Bank of Canada; Statistics Canada; Obstfeld et al. (2016);
Laubach and Williams (2003, 2015); Poloz (2016); calculations PF.
The constraint on BoC monetary
policy is now extremely severe
 The maximum room available for monetary
stimulus is perhaps four times as narrow now than
25 years ago (e.g., 210 b.p. against 825 earlier)
 The chart shows that in the past 60 years, the BoC
nominal policy rate has spent 22% of the time more
than 210 b.p. below the neutral level
 Around the 6 past recessions in Canada, the policy
rate dropped by an average of 755 b.p. – lately by
426 b.p. between October 2007 and April 2009
 This would be impossible today during a recession
that would hit when the policy rate is, say, 1% or 2%
Changes in the policy rate
in the past six recessions
Recession trough High (%) Low(%) Change(p.p.)
March 1961
6.48
2.52
-3.96
March 1975
11.84
6.61
-5.23
June 1980
19.36
8.93
-10.43
October 1982
21.57
8.84
-12.73
April 1992
13.80
5.13
-8.67
May 2009
4.51
0.25
-4.26
Average
12.93
5.38
-7.55
Note: 1-month commercial paper in 1961 and 1975; dates
from Cross (2012)
Raising the inflation target?
 An increase in the inflation target, say from 2% to
4%, would have been sufficient to restore the
available room for stimulus at an appropriate size
 With a decrease of 2 more points in the policy rate
in 2008-2009, the gap between actual GDP and the
no-recession potential GDP could have been closed
by 2011, with about 290,000 more jobs in 2015
 A loss of several hundreds of billions od dollars of
domestic income could have been avoided
The BoC’s objections
1) “There are unconventional monetary policies
(UMPs) that give us more room to manoeuvre”
2) “A higher inflation target would entail imposing a
higher inflation tax on the economy”
3) “There is a low-probability risk that another very
large macroeconomic shock could occur in the future”
4) “Pushing inflation up from 2 per cent to 3 per cent
might be quite difficult to do, given how well inflation
expectations appear to be anchored at 2%”
Source: Poloz (2016)
Objections warranted?
1) UMPs: a) conventional forward guidance is very OK
(e.g., SVE, CZE, NZ), whether or not in recession; b)
QE experiments are far from convincing; c) setting the
policy rate at -0.5% would widen the room just a bit
2) Costs: the vast literature on the costs of inflation has
not produced evidence that inflation within the 0-to4% range can harm the economy significantly
3) Risk: since 1960, the BoC has cut its policy rate by
755 b.p. every 9 years on average to contain recessions:
by no means a “low-probability risk”
4) Anchoring: inflation expectations would not be
difficult to anchor at 4% : we did it nicely in the 1980s
Takeaway (1)
 The policy rate was re-increased prematurely in 2010
 The BoC’s commitment to symmetric inflation
targeting around 2% seems to have been put aside
 Often misleading in the past, the BoC’s conventional
measure of potential GDP again misled it into viewing
the recovery as nearly complete from 2011 on
 The BoC should have moved quickly and aggressively
against the slowness of recovery, in particular to
minimize the possible ensuing hysteresis effects
Takeaway (2)
 The biggest problem faced by the BoC is that it has
been pushed against the ZLB wall by the sharp drop
in the maximum room available for monetary stimulus
 It cannot produce the 755 b.p. drop that was needed
on average to combat the past six recessions
 Unconventional monetary tools such as long-term
asset purchases and a slightly negative policy rate will
not allow the BoC to protect the economy against the
next recession, even if it is just of an "average"
magnitude
Takeaway (3)
 The top priority for now is that monetary and
fiscal policy do everything they can to eliminate the
remaining excess unemployment and to pressure
inflation above 2% (reestablishing symmetry)
 With inflation closer to 3%, there would be, to that
extent, a little more room to decrease interest rates
when the next recession strikes
Clôture
“An economy pushing up against the limits of its
capacity may be just what is required to signal the
need for additional investments and to draw
workers back into the labour force”
Deputy Governor Carolyn Wilkins
(Minding the Labour Gap, 2015)
The convex long-run Phillips curve
Estimated long-run wage Phillips curve showing the trade-off between
aggregate wage growth in the business sector and unemployment
under moderate downward nominal wage rigidity, Canada, 1956-2011
Aggregate wage growth (%)
12
10
8
6
w = 5% p.a.
4
w = 3% p.a.
2
0
4.0
4.5
5.0
5.5
6.0
6.5
7.0
Unemployment rate (%)
Source: Fortin (2015).
7.5
8.0
8.5
9.0