October 30, 2009

Q. What can the Bank of Canada do about the value of the dollar?

A. Usually the Bank can use monetary policy to impact the value of the dollar. But given that the bank rate is already as low as it can go; the Bank cannot use monetary policy to weaken the dollar. But the Bank can intervene directly in the FX market by buying American dollars and selling Canadian dollars. History suggests that such intervention can be useful—at least to a degree. So far, the Bank is not talking about it but if the dollar regains upward momentum in the near future, such an action from the Bank is a real possibility.

Q. Will rising real estate prices force the Bank of Canada to raise interest rates?

A. It is very clear that the recent increase in house prices in Canada reflects a dramatic improvement in affordability. But is it too much of a good thing? The problem with any kind of a bubble is that, in most cases, you know that it’s happening, but you are not sure what do about it. Some argue that the Bank of Canada should raise interest rates in order to make housing less affordable. While this policy makes sense in a booming economy, it does not make sense in an economy that is still trying to find its poles.

The Bank will not raise rates just to deal with the housing market while sacrificing the rest of the economy and risk an even stronger Canadian dollar. So what to do? So far, the Bank is doing nothing, with the hope that we are simply stealing activity from next year. If that is the case then there is no urgency to do anything at this point. But if in the coming six months, house prices continue to rise at current rates and the economy is still in an early recovery mode, the market will start speculating about some direct intervention by the Bank/government in the housing market by altering current regulations regarding insurance and securitization.

Q  How sustainable is the economic growth in the US in the last quarter

A. The 3.5% third quarter GDP growth in the US is clearly unsustainable. Most of the increase was temporary in nature and reflects government spending and a short-lived improvement in the auto sector. My focus at this point is on US business investment which is still falling. That is important given that integral element in formatting the market’s current view is that the Fed will start hiking rates in the second half of 2010 and by that time, business capital spending in the US will be rising by no less than 5% on an annual basis. Given that business spending has been a huge contributor to the US GDP recession, the timing of its rebound will be critical to the timing of a turn to monetary tightening.

The conventional wisdom was that the US recession in the past year was consumer-led, as opposed to the investment-led recession of 2001. But the reality is that the current slump in capital spending is, infact, steeper than the IT meltdown. Back then, the burst of the bubble meant a 12% drop in real capital spending over a two-year period. Currently, as of the third quarter of 2009, and only a year removed from its peak, capital spending is already down by no less than 20%, qualifying it as the steepest slump in business spending in the post-war era. Even as a share of GDP, capital spending is already down to the

Another misconception is that the current decline in US business spending is largely due to the weak state of the American commercial real estate market. But the reality is that, so far, the largest slump in spending was in the machinery and equipment category, which is now down by 21% since the beginning of the recession, compared to a 15% decline in the non-residential real estate component.

Note that the descent in non-residential investment began 6-8 months after spending on machinery and equipment started its nosedive. This suggests that the adjustment in non-residential real estate investment is still in its early stages. Add to it the high correlation of this business investment category with employment growth and the fact that the industrial vacancy rate is now at a dazzling 12%—a record high and a full five percentage points above levels that in the past signaled a recovery, and it becomes painfully clear that any hopes of a turnaround in non-residential real estate investment by mid-2010 are nothing more than wishful thinking.

So, the continuing decline in business investment next year will leave the market’s overall US economic growth expectations light on fuel. While talk in some quarters of a double-dip recession looks to be too gloomy given the huge stimulus still flowing next year, the long wait for a capital spending turn will keep overnight rates at highly stimulative levels for longer than the market now thinks.

Q. To what extent monetary and fiscal policies are coordinated?

A. Officially the Bank of Canada is independent, but it does not mean that it does not take fiscal policy into account while making decisions regarding interest rates. And given the fact that by 2011, fiscal policy will act as a negative for the economy as government will stop spending and start looking for ways to reduce the deficit, it is highly possible that this situation will work to postpone the first hiking move by the Bank, or at the minimum, limits the magnitude of the tightening cycle.