MNI INTERVIEW:Productivity Curbs BOC Cut Enthusiasm-Ex Adviser

The Bank of Canada’s scope for lowering interest rates is limited by sagging productivity and it will take until the second half of next year for policymakers to start easing monetary policy, former BOC adviser Andrew Spence told MNI.

Canadian companies spend only about 60 cents for every dollar American peers invest on gear which makes workers more effective, Spence said, grinding down the pace the economy can grow without adding to inflation. That adds another layer of doubt about whether prices are returning to the Bank's 2% target said the former special adviser now with Validus Risk Management in Toronto.

Governor Tiff Macklem raised borrowing costs to the highest since 2001 at 5% and has left them unchanged at the last two meetings, continuing to warn he may hike again even if inflation remains sticky. Officials also say talk of rate cuts is premature, arguing that inflation risks have risen alongside higher crude oil prices and recent wage gains of 5% are inconsistent with price stability. Dismal productivity dictates that even as the economy slows there will be less drag on prices, Spence said.

“It probably does mean that the rates where they are now are going to stay there for quite a while because it’s going to take inflation some time to get back to two," he said. "Easing isn’t really to my mind a first-quarter phenomenon or a second-quarter phenomenon.”

Another BOC rate hike remains possible if there are more upside inflation surprises, Spence said, and the Fed could even cut borrowing costs ahead of Canada though the American economy is growing much faster. (See: MNI INTERVIEW: BOC Path Tied To Core Prices- Laurier's Siklos)

GOING BACK TO FOUR

Both central banks face a situation where "real" interest rates become more restrictive as inflation continues to slow, Spence said, and at some point officials will decide they need to respond. Canada's real rate, the current policy benchmark minus today's 3.8% inflation, is the most restrictive since 2008 according to National Bank Financial calculations.

“The Bank of Canada doesn’t want to tip the economy over, but nor is it confident that inflation is coming back to be within the target range on a sustainable basis,” Spence said. “So they want this level of pressure to hold.”

Slow progress bringing inflation back to target is a big reason Macklem and Jerome Powell say they could tighten again, and investors have pushed up bond yields as they see the issue in a similar way, he said. Recent comments suggest policymakers see less merit now in further tightening to accelerate the price slowdown, he said.

“I don’t think any of them are in a hurry to take rates higher to get inflation down sooner,” he said. “They have to jawbone it as much as possible to keep the tightening of financial conditions they’ve got in place long enough for there to be an accumulation of capacity which brings inflation into target range more sustainably, and gives them confidence that the job is done.” (See: MNI INTERVIEW: BOC Could Hike Once Or Twice More, Dodge Says)

Slowing inflation allows patience to allow the lagged effect from monetary tightening to rebalance supply and demand, though big rate cuts are unlikely, Spence said. “This isn’t an ease where you go from five back to 25 basis points, unless there’s some disaster, it means going from five to four.”

CHART: Labour productivity has shrunk for every quarter except one in the last two years: