Published in the Globe and Mail on July 15, 2015
Steve Ambler is David Dodge Chair in monetary policy at the C.D. Howe Institute and professor at the University of Quebec at Montreal.
The Bank of Canada’s decision to cut its overnight rate target to 0.5 per cent was expected by many in the wake of the disappointing economic news that’s come since the previous announcement in May. Instead of “a return to solid growth in the second quarter,” as the bank predicted then, gross domestic product growth for the entire second quarter may have been negative.
he bank weighs many factors before making a decision on the overnight rate target. The two main ones are the rate of inflation itself and excess capacity in the economy measured by the output gap. The latter captures inflationary pressures and serves as an important predictor of future inflation.
While it is difficult to second-guess the bank, given the vast resources at its disposal to gather and process information, there are reasons to think that its estimate of the output gap may overstate its size.
The output gap is the difference between actual GDP and “potential” output. The latter is not observable and is estimated by the bank using either a smooth statistical trend or smooth trends in the growth of the total labour force and of labour productivity.
The oil price shock that is the main cause of Canada’s slow growth in the past six months necessitates a reallocation of resources between the energy sector and the rest of the economy, as well as a geographical reallocation given the concentration of the energy sector in Alberta, Saskatchewan and Newfoundland, and of manufacturing in Central Canada. This takes time and resources. Labour that leaves the oil patch also loses sector-specific skills. All this means a decrease in productivity and a fall in potential output not captured by smooth trends. The actual output gap could be smaller for this reason.
A more important consideration is the impact of the fall in oil prices on Canadians’ real incomes. The 50-per-cent drop in the price of oil in the last quarter of 2014 does not have a direct effect on the conventional measure of real GDP (calculated using constant prices). However, the purchasing power of Canada’s output has clearly fallen. We can purchase less imports for a given quantity of energy exports, a worsening of Canada’s “terms of trade.”
The drop in oil prices looks as if it may be quite persistent. This will have a permanent effect on the spending decisions of the average Canadian, translating into a drop in real domestic demand. Total aggregate demand could only remain on its previous trend to the extent that net exports increase permanently. While they will recover from their disappointing recent performance, a permanent increase is unfeasible. Total demand is on a lower trend than before the oil price shock. Supply will have to adjust to that lower trend and may have already begun to do so. The difference between current GDP and a smooth trend line once again overstates the true size of the output gap.
For these reasons, the rate cut may have less of an impact than the bank would like. The stimulative effects are also likely to be weak due to a limited effect on market interest rates. TD cut its prime rate by just 0.10 percentage points Wednesday; variable-rate mortgages may hardly budge at all. Also, the Alberta government is studying a possible increase in oil royalties, and national spending on durable goods and investment may be on hold pending the results of October’s federal election.
The Canadian economy will return to 2-per-cent inflation and full capacity in the long run. However, even full capacity will leave us worse off than where we would have been without the oil price shock. The next rate announcement, in September, may reflect a growing realization of a smaller gap and a lower growth path for the economy.
