By any standard, the Bank of Canada has handled things very well over the past decade: inflation is low and stable, and employment rates have been at all-time highs over the past couple of years.
But things are starting to get more complicated.
Here’s a graph of the US federal funds rate and the Bank of Canada’s Bank rate:
The Bank of Canada and the Federal Reserve have both been raising interest rates over the past year or so, but the Fed has been much more agressive.
The Fed has its own reasons for doing what it’s doing – what is the Bank doing? Since its adoption of inflation targets, it’s paid close attention to the output gap (the difference between actual GDP and the level at which there are no inflationary of deflationary pressures):
It would appear that the Bank is being rather timid this time around: the Bank rate is roughly two percentage points lower than it would have been in similar circumstances over the past decade.
So the next question is: why? My guess is that the people who set interest rates are less than convinced that the Canadian economy really is operating above capacity. It’s not just that the output gap estimates have rather large error bands; they must know – as I mentioned earlier – that fixed business investment has been on quite a tear recently, so it would presumably be the case that capacity has grown at a correspondingly faster rate as well. Here’s a graph of the growth rates of GDP and Statistics Canada’s estimates for the capital stock:
During the previous two expansions, output growth significantly outstripped the rate of growth of the capital stock, so the case for raising interest rates was fairly clear. That’s not the case this time.
The Bank of Canada does not make public its methodology for constructing its estimates for the output gap, but I wonder what role investment plays in that exercise. In the short run – the horizon in which the Bank is forced to operate – current investment has an imperceptible effect on productive capacity. But several years of strong investment has got to add up.
So far, the Bank has handled things very well (did I mention the low inflation and high employment?). But it’s going to be tricky dealing with the following issues over the next few months:
- Ontario Premier Dalton McGuinty’s predictable, public and partisan complaints about the appreciation of the CAD.
- Figuring out how the surge in investment has affected measures for capacity.
- Guessing what the Fed will do over the next few months.
Worthwhile Canadian Initiative 
If you could have a CAD that was “overpriced” and stable in PPP terms over each of the next 100 years, or underpriced and stable, which would you pick?
Export industries with low import components would prefer underpriced of course, but it seems to me that for everyone else (in Canada) an overpriced CAD would be beneficial to their standard of living.
It always amuses me, amazes me, and saddens me that there are politicians who put actually prefer something besides a strong currency. Public choice rears its ugly head once again.
These are certainly hard questions, and Ontario’s premier is certainly not helping in resolving any.
I would add that the rise of natural resources prices, and the associated appreciation of the CAD against the USD, have strenghtened the terms of trade. This makes all imported intermediate goods entering the production process cheaper. If this is seen as a permanent change in the structure of FX rates, this is equivalent to an increase in productivity.
This effect may also lead to substantial change in the structure of production as manufacturers increase the import-content of output. This lasting effect may also justify why the Bank of Canada looks timid compared to current measure of output gap.
Are you still indulging that silly little science called Econometrics?
That’s what we call ‘eyeball econometrics’.