"There was a time when strong money growth prefigured a robust economy, and sharp drops like we see today would have worried central banks."
Bank of Canada Governor Stephen Poloz punted the “Will He or Won’t He” rate watch to July when the Bank of Canada left its target overnight rate unchanged on Wednesday. Markets had factored in only a 17 per cent chance of a hike, so there was little surprise. Looking ahead, there is a lot to get excited about for the Canadian economy, but in the near term, a few worrying signs justify leaving rates alone. Most of these signs have appeared repeatedly in Bank of Canada communications – but for one: falling money growth. And it deserves more attention.
First, the rosy side of the ledger. Headline inflation is now above the 2-per-cent target, and the bank’s measures of core inflation are all close to 2 per cent. Canada’s unemployment rate has not been this low since October, 2007. Including strong exports, recovery in investment, and robust labour income growth, data seem to overwhelmingly suggest it is time to start normalizing the overnight target rate toward a so-called “neutral rate of interest ” that is compatible with the economy running at full capacity and inflation at target. The bank currently estimates this neutral interest rate to be approximately 3 per cent.
However, not all is rosy. So-called “headwinds” – read uncertainty – are holding back the upward march of the bank’s policy rate. In its communication, the bank emphasized one such headwind: the negative impact trade uncertainties are having on global business investment. Here at home, the outcome of the negotiations on the North American free-trade agreement is still unclear, and this has not helped business investment that has struggled in Canada for quite some time. The announcement by the federal government that it is buying out Kinder Morgan’s stake in the Trans Mountain pipeline has not completely alleviated the uncertainty surrounding that particular project, and regulatory uncertainty continues to affect other major Canadian infrastructure projects.
For those that regularly read the bank’s press releases following policy-rate announcements, none of these headwinds are new. However, there is another concern not getting much attention these days, despite making up a big part of the monetary policy discourse a generation ago: Canada’s money stock. Worryingly, the money stock has seen falling growth rates since last year. This is true of both narrow money (M1+ and M1++) – think about cash and money in your chequing account – and broad money (M2++) – think about money in your savings account.
The year-on-year growth rate of M1+ (5.4 per cent) has not been this low since 2005. And last month, the year-on-year growth rate of M1++ (4.1 per cent) fell to a level not seen since April, 1999. Growth in broader money (M2++) has been on a downward trajectory and is at a lower pace (5.2 per cent) than at any time since 2011. The deceleration in the growth of M2++ is as steep as the one that coincided with the financial crisis. This is remarkable, since recent increases in the bank’s policy rate should have shifted demand from low-yielding components of the money stock such as demand deposits (included in M1+ and M1++) to the higher-yielding liquid assets included in broad measures of the money supply such as M2++.
There was a time when strong money growth prefigured a robust economy, and sharp drops like we see today would have worried central banks. Monetarism reigned supreme in the 1980s and even into the 1990s as central bankers used money supply as a way of taming high levels of inflation. However, the relationship between money growth and spending disappeared in the 1990s as transaction velocity – how often a unit of currency is used in a given period of time - became unpredictable. As a result, the Bank of Canada increasingly ignored the behaviour of monetary aggregates in formulating its monetary policy.
However, a strong correlation still exists between the growth in monetary aggregates and the growth in nominal spending and inflation in the long term. And, in the low interest-rate environment we’ve had for so long, this relationship might stabilize further.
Without a lot of research on monetary aggregates these days, it is hard to provide a concrete explanation as to why we are seeing these sharp drops. But, if it does reflect a financial system that is creating less money, then the economy may not be bounding ahead quite as we hope. Therefore, the bank’s cautious approach to increasing its overnight rate is entirely sensible.
Steve Ambler is the David Dodge Scholar in Monetary Policy at the C.D. Howe Institute, and professor of economics at the school of management, University of Quebec at Montreal. Jeremy Kronick is associate director, research, at the C.D. Howe Institute.
Published in the Globe and Mail
