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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