Mark Carney, the governor of Canada’s central bank (Bank of Canada), must be one of the most relaxed central bankers in the Western world. In an interview posted on Paul Kedrosky’s website (minutes 9 to 35), Carney admits that his job is easy compared to the task still facing many of his contemporaries. For example, Canada’s economy has recovered from its recession with GDP and employment essentially back to pre-recession levels. However, I was a bit surprised to hear Carney indicate he now has the luxury of preparing Canadians for a future with higher interest rates given the Bank of Canada issued the following words of caution in October’s monetary policy statement:
“At this time of transition in the global recovery, with a weaker U.S. outlook, constraints beginning to moderate growth in emerging-market economies, and domestic considerations that are expected to slow consumption and housing activity in Canada, any further reduction in monetary policy stimulus would need to be carefully considered.”
(I wrote a summary of the full statement here in “Bank of Canada Confirms Carney’s Caution).”
Carney also noted in September that Canadian monetary policy cannot diverge to far from U.S. policy…and we all know that U.S. monetary policy is getting looser before it tightens, especially after Friday’s weak employment report.
Nonetheless, Carney’s interview was insightful and fascinating; it motivated me enough to take notes. I have posted these notes below, organized into what I found to be the most important themes. I also inserted a few editorial comments. As always, I highly recommend you listen to the interview for yourself.
History
- The Bank of Canada grew out of the Great Depression from concern that credit was not moving through economy, especially in the Western provinces.
- Before the Bank of Canada, Canada just had ordinary commercial banks. There was no effective lender of last resort.
- Since the early 1990s, the Bank of Canada has a mandate from the government to set an official inflation target of 2%. The Bank uses its discretion to achieve the target.
- The Minister of Finance under the Bank of Canada Act can write a directive to the Bank of Canada to change its monetary policy. This capability acts a safety valve and would signal a lack of confidence in the central bank. It has never been used.
- The Bank of Canada relies on the media to translate changes in view. There was a time in central banking when “constructive ambiguity and obfuscation” was highly valued. (Me: I wonder which former central bank governor of a major superpower directly south of the Canadian border could Carney be referencing here?)
- The Bank of Canada is not trying to be ambiguous: tell it like it is and communicate the risks, be careful but also transparent.
Canada and the world on the brink
- During 2008, the central bank absolutely needed to provide liquidity:
Canada got within 36 hours of a seize-up of its financial system. - When Carney entered the G7 meeting in Washington, it was clear that the global financial system would seize up if decisions were not made.
The emergency measures
- Banks have been forced and cajoled into holding more capital.
- Major debts which were funded through short-term borrowings have been transferred onto governments where debt structures are longer-term. (Me: I think this is the first time I have heard a central banker so directly and clearly describe this process).
- It is a different dynamic as the [government debt] unfolds: the process will take years to unfold unlike the days it took in 2008. (Me: so we bears on European sovereign debt must exercise patience?)
- There were two big events: the recapitalization of the U.K. system; and stress tests on U.S. banks at the onset of the Obama administration followed by a major recapitalization.
- The 19 largest banks, representing 85% of the banking capital in the U.S., were forced to raise the capital needed to meet the stress tests. This process removed a veil of uncertainty.
- Europeans did a similar thing in Spring; it had an important increase in transparency. (Me: I think Carney felt obligated to give Europe’s stress test some credit.)
Stresses remain
- There are stresses in the global financial system, without question. It will take years to play out.
- Policy decisions will continue to matter.
Currency manipulation
- In the Fall, roughly 40% of the currencies in trade-weight with the U.S. dollar were managed to some extent – these countries are using currencies instead of tariffs.
- This manipulation does not work in the long-term. Ultimately, the adjustments to currencies will come through relative inflation differentials.
- For example, China vs the U.S.: if China’s currency does not move, then the real value of Chinese goods will increase. There will have to be higher inflation in China than in the U.S.
- The Bank of Canada has said for years that China’s inflation is accelerating and the U.S. is decelerating.
- Getting a more difficult adjustment than if currencies were allowed to adjust.
- Canada has some protections: the Bank of Canada is not naive in this situation. In the extreme, it can intervene in currency markets if economic outcomes are threatened.
- Very importantly, the level of currency is very relevant for Canada’s mandate. It effects the outlook for inflation. The Bank would not hesitate to use policy if needed to protect mandate. (Me: always fascinating to hear central banker’s opinions on their native currencies since the Federal Reserve, until recently, takes pains not to discuss relative currency levels.)
A future with higher rates
- Interest rates in Canada are abnormally low.
- The risk is that some Canadians take on debt that assumes rates will be this way for some time. This is not a sensible assumption with 30-year mortgage debt. (Me: talk about plain language!)
- Afraid people will get into situations that will make it hard to service their debts.
- Taking a longer-term perspective by providing as much transparency regarding the long-term path. Interest rates will go higher, Canadians need to be comfortable they can service debt at higher rates, and banks also need to be comfortable with this.
Too big to fail and financial regulation
- Canadian banks are absolutely not too big to fail.
- In Oct, 2008, central banks had to stand up and say they will protect their banks with enough liquidity to keep them functioning.
- The problem is that the market thinks that until proven otherwise, banks are too big to fail. We have to get rid of that (heads we win, tails you lose attitude from private markets).
- Market will not function in a free way without proper structure and adequate regulation.
- There are some institutions that provide critical functions in the financial system. There has been the need to save them because of worry they can bring down entire system.
- Need to change the entire infrastructure of these markets where one of these failed banks can be snapped off and the rest of system can continue to function.
- For example, we may not like the price in the stock market, but it does continue to function.
- It is totally unacceptable to have the entire bond and derivative markets seize up because of a failed bank.
- It is our responsibility to re-instill the actual discipline of the market – the fact that banks can fail and be wiped out.
- Have to make a series of changes to do that. Change in infrastructure is one of them. (Me: Canadian banks, consider yourselves warned.)
- We have a pretty good idea – and a better record than most central banks – for forecasting the Canadian economy 12-18 months out.
- This range happens to be our horizon for planning our inflation target.
- There are times like today when the band of risks around the forecast are higher. Will continue to be transparent about the “positive and negative” risks to that forecast.
Be careful out there!
Full disclosure: no positions