MNI INTERVIEW: BOC Will Taper to Avoid Market Squeeze--Dodge

The Bank of Canada will keep paring back weekly government bond purchases to avoid amassing a stockpile that distorts market pricing, former Governor David Dodge told MNI, adding policy makers can manage 3% inflation through most of next year without seeking a deliberate overshoot like the Fed's.

"They are going to be moving off, if only because you don't want to own all of that debt -- you have to have that debt out there in the market to give you the right signals," Dodge said about quantitative easing in a phone interview.

Current Governor Tiff Macklem says the main driver of how he calibrates bond purchases is how soon lower borrowing costs for consumers and businesses hasten a return to full output and inflation stabilized around his 2% target. He has downplayed arguments the BOC is helping finance record government deficits or may end up damaging bond trading.

While Macklem slimmed the CAD5 billion pace he inherited last year from Stephen Poloz to CAD3 billion including a second taper last week, the diminished clip may not stop the central bank's share of the federal bond market from rising. That's because the latest federal budget also reduced the pace of new debt auctions.

"Issuance is going to be way down and you can't have the bank owning that hugely greater share of the federal debt then they now own," Dodge said.

TOP OF BAND INFLATION

Canada leads major central banks with purchases of 35% of the federal debt stock since the pandemic broke out. Total holdings are now 42% of the stock and some investors complain the BOC was on track to own half the market this year. Macklem at times has said he has lots of room to expand QE if the economy needs more support.

Bond yields are also rising without a tantrum seen in the U.S. when the Fed tapered following the emergence from its recession about a decade ago, Dodge noted. That held true even last week when inflation jumped to 2.2% in March from 1.1% in February, while Macklem announced the second QE taper and advanced his timeframe for hiking the 0.25% policy rate to the second half of next year.

Dodge predicted inflation may hang around 3% -- the top of the BOC's symmetrical target range around its 2% goal-- for the next 12 to 18 months. "I fully expect we are going to have something close to the top of the band for 18 months or so going forward, and I'm not particularly worried about that," he said.

Much of the pressure comes from industries shifting production through the pandemic and the BOC should let that process happen, Dodge said. "Our system certainly contemplates short periods when you are going to run above the 2% target and other periods where you may run below, but that our target remains 2% and we won't try to offset short-term disruptions."

BUDGET ISN'T CREDIBLE

The BOC is due to renew its five-year inflation target agreement with the government this year, and Dodge suggested emulating the Fed's average inflation targeting by allowing an overshoot could lead to an unwelcome reset of price expectations. "I worry about that sort of catch-up philosophy that seems to be there -- that may prove a problem down the road," Dodge said.

Dodge, who also served as the finance department's top official, had some sharp criticisms of the latest federal budget. Finance Minister Chrystia Freeland laid out CAD100 billion of deficit spending even with the economy rebounding and gave no specific fiscal restraint target.

Assumptions about economic growth, continued low interest rates and holding down per-capita spending over many years are questionable, meaning federal finances are unlikely to stay on track without higher taxes, Dodge said. Extra spending also missed the mark on helping key industries such as energy, manufacturing and financial services prepare for a low-carbon economy, he said.

"It's not a credible budget going forward," and "it is not a growth budget," Dodge said. "Tax increases are pretty much inevitable in order to put you on a medium-term fiscal track which makes sense," Dodge said, and an increase worth 2 percentage points of GDP may be required.