This article first appeared on CanadianBusiness.com
Late last year, the Federal Reserve said it would keep the federal funds rate near zero until unemployment drops to 6.5 per cent, as long as inflation doesn’t rise past 2.5 per cent. Both targets might still seem a long way away. The jobless rate has fallen considerably in the past few months—from 8.1 per cent in August to 7.5 per cent in April—but that was due to both hiring and disaffected workers dropping out of the labour force. Consumer price inflation, meanwhile, has climbed at a tame 1.1 per cent rate since April of last year.
Yet, the beginning of the end of the Fed’s quantitative easing (QE) policy, its $85 billion-a-month bond-buying program, could be near. The economy grew at a respectable 2.5 per cent in the first quarter, and is holding up better than expected in the April to June period thanks to consumers who seem to have shrugged off payroll tax hikes and spending cuts. And as the wheels of the U.S. economy finally start to turn a little more smoothly, concerns are growing inside and outside the Fed about cheap money flowing to poorly regulated corners of the financial system and once again inflating asset bubbles. “We are watching particularly closely for instances of ‘reaching for yield’ and other forms of excessive risk-taking, which may affect asset prices and their relationships with fundamentals,” Fed Chairman Ben Bernanke said earlier this month. It is not inconceivable that the bank could start tapering off its assets purchases before the end of the year.
What would that mean for Canada and its new Bank of Canada chief, Stephen Poloz? Depriving the U.S. economy of the punch bowl of monetary stimulus, as one former Fed chairman famously called it, would affect Canada mainly in two ways: through export demand and the exchange rate. On the one hand, tighter monetary policy would slow down U.S. GDP growth and reduce aggregate demand for Canada’s goods and services. On the other hand, higher U.S. interest rates would make Uncle Sam more attractive to investors, leading to an appreciation of the greenback, which would, in turn, make Canadian exports relatively cheaper. Needless to say, it isn’t obvious whether the net effect would benefit or harm Canada.
That said, the Fed isn’t going to suddenly pull the plug, says Christopher Ragan, an economics professor at McGill University and a former special advisor to the Bank of Canada. “If the analogy is driving a car,” he says, “you don’t just slam on the brakes… typically what you do is you slow down, and then you stop and then you put it into reverse.” That’s likely how the Fed is going to proceed: first reduce the size of the monthly purchases of Treasuries and mortgage-backed securities, then halt them altogether, then possibly start selling those assets back (although a number of Fed officials recent said they might hold on to some of the assets the bank has been buying until maturity). The process of winding down QE could start in the next few months, he says, but “we might not see significant increases in interest rates in two years.”
The deceleration from $85 billion a month to $0 does indeed sound potentially tortuous, according to a recent article in the Wall Street Journal, which is widely believed to be the Fed’s favourite conduit of information aside from officials’ statements. “Officials say they plan to reduce the amount of bonds they buy in careful and potentially halting steps,” wrote the Journal’s Jon Hilsenrath, describing the Fed’s so-called “exit strategy.” He added that the Fed could even step up its purchases if its confidence in the health of the economy falters, although no economist surveyed by the newspaper expected that to happen.
One more thing to consider is that Canada could well start tightening its own monetary policy before the U.S. does, noted Ragan: “Canada is closer to its potential today than the U.S. is.” Potetial is the level of output an economy would produce at full capacity, that is, when virtually all job seekers can find employment, offices are full and all machinery and equipment put to productive use. If the economy overshoots that ideal level, inflationary pressures usually become significant.
That’s not to mention fears that Canada’s own easy money has inflated a housing bubble that tighter mortgage rules alone can’t deflate, and could promote excessive risk-taking among investors, discourage fiscal discipline (especially among provincial governments) and keep uncompetitive zombie companies afloat via cheap credit. That’s why Paul Masson, an economics professor at the University of Toronto and another former Bank of Canada special adviser, urged the Bank of Canada this week to hike rates soon.
Anything that pushes the loonie up relative to the U.S. dollar is likely to produce grumblings from Canada’s export-oriented manufacturers, but Stephen Poloz might get to become the target of those complaints before Bernanke has even has time to say “exit.”