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Ed Devlin, Richard Clarida
What is the correct policy response to a prospective asset bubble? This question has been the focus of considerable academic research, especially since the financial crisis of 2008. Recent communication from the Bank of Canada (BoC) suggests it is considering hiking policy rates in response to the recent surge in household debt and home prices. If it does, this could represent a decisive change in its inflation-targeting strategy for monetary policy. At a minimum, it would get the attention of public policymakers worldwide owing to Bank of Canada Governor Mark Carney’s position as chair of the G20 Financial Stability Board (FSB).
Governor Carney gave an important speech last month titled “Uncertainty and the Global Recovery” in which he put investors on alert that the Bank of Canada stands ready to deflate a potential Canadian housing bubble by raising the overnight rate. He was clear that capital flight into Canada that distorted the value of the Canadian dollar and lowered longer-term interest rates is factored into setting monetary policy. He also said “if” the Bank of Canada were to “lean against emerging imbalances in household debt,” it would clearly communicate this and its implications for returning the economy to the target 2% inflation rate (i.e., provide an estimate of the delay to get back to the inflation target via the flexible inflation-targeting regime of the Bank of Canada).
Although Governor Carney will leave the BoC in June 2013 to become governor of the Bank of England, his successor at the BoC will likely grapple with the same macroeconomic situation and is likely to follow a similar course, in our view.
“Old Normal” conventional wisdom: react to asset price volatility Prior to the 2008 financial crisis, price stability and financial stability were widely viewed as complementary (not in conflict). The credit markets were broadly viewed as efficient. Securitization was seen as a helpful tool to diversify credit risk among many sophisticated investors. While policymakers such as former BoC Governor David Dodge were concerned about global imbalances, not much research was done on the unintended consequences of monetary and/or currency policies on credit markets.
Former Federal Reserve Chairman Alan Greenspan widely espoused the view that it was very hard to tell (ex-ante) whether asset price appreciation was caused by speculation or reflected fundamental changes such as advances in technology. The role of central banks was to focus on the real economy and price stability, and to use monetary policy (ex-post) to deal with the confirmed bursting of an asset bubble if it had adversely affected the real economy or inflation, rather than use monetary policy pre-emptively by tightening. Current Fed Chairman Ben Bernanke validated this view in his seminal article with Mark Gertler, “Monetary Policy and Asset Price Volatility.” The U.S. Federal Reserve’s responses to the 1987 stock market crash, the bursting of the technology bubble and the 9/11 attacks were broadly seen as successful validations of this approach.
New Normal theory: macro-prudential policy response The 2008 financial crisis, however, showed there can be a conflict between price stability and financial stability. Policymakers and academics have since spent considerable time studying and implementing “macro-prudential” policies, which aim to mitigate risks to the financial system as a whole.
The Canadian government’s four rounds of mortgage credit tightening over the past four years are good examples of macro-prudential policies. The main objective has been to mitigate the rise in consumer indebtedness and house price appreciation to prevent future shocks to the Canadian financial system.
BoC’s concern about the household sector warranted The Canadian financial system in 2012 is suffering from some of the same financial market distortions that were evident in the U.S. and other developed markets before the crisis. Specifically, domestic policy to promote home ownership and policies of foreign governments have combined to lower mortgage rates and increase household indebtedness.
Since the crisis, the Canada Mortgage and Housing Corporation (CMHC) has rapidly expanded the amount in mortgages it guarantees, thereby lowering mortgage rates (see Figure 1). Also, several major central banks (the Fed, the Bank of England and the Bank of Japan) have zero interest rate policies and are engaging in quantitative easing (QE), in which the central bank buys government bonds to depress interest rates. This has caused capital flight into Canada where the policy rate is 1% and the BoC is not engaged in QE. This capital flight (see Figure 2) into Canada is depressing bond yields and lowering mortgage rates.
As a result, Canadian consumers have increased their mortgage debt and bid up housing prices (which in turn causes builders to build more houses), as shown in Figures 3 and 4. The unwinding of these imbalances could be disorderly, and this rightly concerns the Bank of Canada.
New Normal reality: implementing macro-prudential policies Canadian Finance Minister Jim Flaherty and Governor Carney are trying to slowly let the air out of the household debt balloon, which is a difficult task. The government has already tightened mortgage credit four times (see Figure 5). It is hard to know how much of an effect the previously announced macro-prudential tightening has had and how much more it will have in the future.
What does PIMCO think the Bank of Canada will do? In our view, the recovery in Canada is still fragile and the Bank of Canada will need to see stronger growth data before considering a rate hike to “lean against emerging imbalances in household debt.” The bank is appropriately proactive in communicating the framework for such a macro-prudential rate hike. Its communication strategy is also a moral suasion tool to encourage consumers to be prudent in taking on more debt.
Before the Bank of Canada uses the blunt tool of monetary policy for macro-prudential reasons, we believe the federal government will try at least one more round of mortgage credit tightening, which could involve:
If the Canadian economy manages to sustain 2%-2.5% real growth, as the Bank of Canada forecasts, the current estimated output gap of 0.67% will close, and we believe the bank will hike rates because of concerns about inflation over the intermediate term. A traditional Taylor Rule analysis, which gauges how a central bank should set short-term interest rates to achieve both economic stability and its inflation goal, currently justifies the Bank of Canada’s tightening bias (see Figure 6). This analysis also supports our view that the next BoC governor will likely follow the same path as Carney would have based on the outlook for inflation and the output gap in Canada.
To be clear, our baseline forecast is that the Bank of Canada will eventually hike rates mainly for traditional concerns about inflation and the business cycles and will also talk tough on consumer debt (more moral suasion). This is different than hiking for macro-prudential reasons because it will not delay getting back to the inflation target. Said another way, this would not be a macro-prudential tightening of monetary policy because there is no conflict between the policy required for price stability and that required for financial stability.
Canada would not be the first central bank (post crisis) to mention housing when raising rates. On October 28, 2009 the Norges Bank Executive Board increased rates in Norway by 0.25 percentage points to 1.5% and stated: “[I]nterest rates are low, resulting in renewed growth in household consumption. At the same time, house prices are rising. Over time, household borrowing may surge again…”
What are the implications for other countries? If the Bank of Canada hikes rates for traditional concerns about inflation and combines the rate rise with moral suasion language about the housing market, the implications for other countries will be limited.
If the Bank of Canada hikes rates for macro-prudential reasons (i.e., delaying getting back to the inflation target in order to promote financial stability), this could have significant implications for other markets. The message from global FSB Chair Carney is that if a country has substantial household imbalances, then hiking rates (despite a below-target inflation forecast) is appropriate. Countries such as the U.K. and Australia may be more inclined to tighten monetary policy than current market forward rates imply. If this macro-prudential tool is used, a number of questions would naturally follow. How much tightening is appropriate? How does a central bank know when it has done enough macro-prudential tightening? How is financial stability measured? It would take some time to determine frameworks to answer these questions.
Investment implications: position for reflation Given PIMCO’s baseline forecast of a fragile 1.5%-2% in real growth in Canada over the next year, we do not expect the Bank of Canada to increase interest rates to “lean against emerging imbalances in household debt.” If household imbalances continue to build, we expect another round of macro-prudential tightening of mortgage credit. In the short-term, we do not see a major bear market in Canadian rates but expect the market will gradually anticipate the next move being a modest tightening cycle in Canada. With break-even inflation (BEI) rates at approximately 2% (the Bank of Canada target), we prefer real return bonds to nominal bonds as nominal bonds do not provide enough compensation for inflation risk.
If we are wrong and the Bank of Canada hikes rates to “lean against emerging imbalances in household debt,” then we should see sharply higher rates in Canada. In addition, there could be spill-over effects in other major markets such as Australia, the U.K. and possibly the U.S. The two main effects would likely be higher nominal rates as the increased probability of earlier rate hikes gets priced in and higher volatility due to increased uncertainty over the new policy goals.
All investments contain risk and may lose value. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk; investments may be worth more or less than the original cost when redeemed. Real Return or Inflation-linked bonds (ILBs) issued by a government are fixed-income securities whose principal value is periodically adjusted according to the rate of inflation; ILBs decline in value when real interest rates rise.
There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market.
This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. There is no guarantee that results will be achieved. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO and YOUR GLOBAL INVESTMENT AUTHORITY are trademarks or registered trademarks of Allianz Asset Management of America L.P. and Pacific Investment Management Company LLC, respectively, in the United States and throughout the world. ©2012, PIMCO.
No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 840 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2013, PIMCO.
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