Published via email 12 April 2022. Request to subscribe to private email list.
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The Bank of Canada is scheduled to make an interest rate announcement Wednesday, April 13th (tomorrow) around 10 AM EST.
The question is if we are going to see a 0.25% or 0.50% rate hike?
I think a case for either scenario can be made quite reasonably.
The overwhelming market consensus has priced in a increase of 0.50%. I’m going against the grain (again) formally stating I anticipate a 0.25% rate increase.
Let’s consider some of the following data:
A Case For 0.50% Rate Hike:
At a high level, inflation is rising quickly and unanchored for several reasons:
1. Fiat money printing.
2. Purchase demand.
3. Supply constraints.
4. Inflation expectations.
Fiat money: There was a time that every U.S. dollar could be exchanged for a gold equivalent. This gold standard put a limit on the amount of dollars that could be created for circulation because the U.S. federal reserve actually had to have stores of gold backing the dollars. In 1971 the Nixon government broke this gold standard so the government could create money, for various reasons.
Today we continue to be in a system where the supply of money can be created without any constraints. The current term for this money creation paradigm is Modern Monetary Theory (MMT). Whereby central banks monetize government debt which is used in various ways to stimulate the economy/markets. This is inherently inflationary.
Purchase demand: Pandemic savings rates have been well documented. With many Covid restrictions lifting and economic conditions improving, consumer demand is returning to pre-pandemic levels. With demand outstripping supply (similar to Calgary’s Real Estate market) that puts upward pressure on pricing which is inflationary. People’s savings are being spent.
Supply constraints: Supply constraints are still prevalent in goods producing sectors of the economy. These supply constraints were initially dubbed “transitory” because as the constraints pass (and they eventually will) there will be a balancing of supply and demand again.
Inflation expectations: Consumer inflation expectations can propel a self fulfilling prophecy. If I think goods/services will be more expensive in the future, due to inflationary pressure, the tendency is to pull forward my purchase demand. If the majority of consumers adopt this philosophy, that decision making fuels inflation. Inflation expectations become “unanchored”.
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The high level idea in aggressively hiking rates is slowing purchase demand enough to lower inflation and inflation expectations. The policy risk in this approach is damaging areas of the economy that have benefited from ultra accommodative monetary policy (housing and equity markets).
I think the evidence is clear, central bank tightening is behind the curve. Looking back, monetary tightening should have started much earlier. A growing fear is inflation is becoming more structural.
A Case For 0.25% Rate Hike:
Inflation is here, which requires monetary tightening. The economy is past the doldrums of the pandemic and does not require emergency monetary stimulus to survive. A more cautious approach might be executed to tame inflation for some of the following reasons:
1. Peak inflation is behind.
2. Monetary tightening.
3. Supply constraints ease.
4. Long-term deflationary forces take hold again.
5. Foreshadowing of weakening economic data is surfacing.
Peak inflation: I’ve found historically the Bank of Canada “looks through” current data and anticipates what our economy might be like in the medium-term.
One could make the argument rate hikes could have started last Summer in anticipation of today’s inflationary numbers. I agree. Today, this has eroded confidence in the bank’s ability to do what is necessary to ease inflationary concerns.
Perhaps the BoC again looks out into the future, and estimates peak inflation is behind us. If this is their conclusion, rather than chasing a lagging economic indicator like inflation, they might look through and anticipate inflation is easing?
Monetary tightening: There are other angles that monetary tightening is already taking place in our economy – without the BoC doing anything. I am primarily thinking of the fixed interest rate Mortgage market.
A general rule of thumb I think about is a 1% rise in interest rates is equivalent to a 10% headwind in Real Estate. The parabolic rise in fixed interest rates will take time to show up in housing data because Real Estate is a lagging economic indicator. A slowing of the housing market is likely to have a negative wealth effect. This means I spend less because I feel less wealthy when the value of my house is lower.
Supply constraints ease: Supply constraints will eventually move beyond Covid restrictions. The saying “this too shall pass” comes to mind – just look how far we have come since March 2020. At some point in the future, Covid related supply constraints will pass.
Long-term deflation: There are still deflationary forces in the economy that that can become more influential again. These forces are a) aging demographics, b) disruptive technology and c) debt. These deflationary forces have been a part of long-term deflationary pressures, and have not “gone” anywhere.
Weakening economic data: A historically accurate recession indicator is the “inversion of the yield curve“. A inverted yield curve means the return on money invested is higher over the short term, compared to investing money over the long-term.
Typically, investing money over the long term yields higher rates of return because the invested capital is tied up for longer. The risk profile over a longer time horizon is greater.
Typically, shorter term investments provide lower rates of return because capital invested is at risk for a shorter period of time.
Today the yields of short term versus long term investments are inverted. The market is saying there is more risk in the short term which is interpreted as foreshadowing for a slowing economy.
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This more cautious rate hike camp is concerned with a policy error of tightening interest rates into a weakening economy, tipping the system into a recession. A slower, more cautious rate hike approach is trying to find that “soft economic landing”.
Conclusion:
In general, I’m hearing and reading a reasonable amount of conflicting thoughts for aggressive rate hikes or more cautious rate hikes.
With these kinds of contrasting thoughts, I can’t help but think nobody knows what the hell might happen!!
In many situations like this, I think the answer is likely somewhere in the middle. Could the Bank of Canada slap the market with a 0.50% rate hike Wednesday? Yes. Perhaps afterward they pause for a longer period of time to allow further data to surface to support their next move?
Could the Bank of Canada raise rates by 0.25% in April and raise rates again in June by 0.25%? Perhaps we achieve the same result of a 50 basis point rise just over a longer period of time? I think that’s also possible.
What nobody is speaking about is rate cuts. Yes, rate cuts! Let’s not forget the market cycles. The higher rates rise, the more exposure I have to rates falling in the future.
There you have it. I’m calling for 0.25% rate hike on Wednesday. What do you think?
Talk soon,
Chad Moore
P.S.
Ok, tin foil hat time. Some of you love this. Another idea is that policy makers secretly want higher inflation. With so much debt in the system, inflation erodes the value of the debt required to be repaid in the future. The debt is worth less. Government debt is so large, and financial markets are so dependent on stimulus that a rug pull (i.e., aggressively hiking rates) would be detrimental to the economy. We have a lot of “tough talk” but the policy implementation might not be executed to the same extent.
Ah, one to many late night Youtube videos :-). Tin foil hat off now.
P.P.S.
Mortgages. I hope this content is helpful in your Real Estate planning. Reach out if you might need financial leverage to help bring your plans into existence.
