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Faced with the gravest global health emergency in a century, monetary policymakers around the developed world responded with unprecedented speed and scope, and largely in the same manner. From the United States to Australia, they unleashed the twin stimuli of ultra-low interest rates and quantitative easing, and added on other extraordinary measures, such as emergency credit facilities, for good measure. But the landscape has changed. In much of the West, vaccination campaigns are gaining traction and economies are groping towards recovery. Today, the task before central banks is less about responding to the pandemic and more about responding to its ending.
How and when they will turn off the taps of quantitative easing and begin to normalize policy rates are matters of great importance, of course, but one point is already evident: The unified front presented by monetary policymakers over the past 15 months or so is beginning to show some cracks.
Conveniently for domestic fixed-income investors, one of the best illustrations of policy divergence is presented by two neighbouring central banks right here in North America: the Bank of Canada and the U.S. Federal Reserve.
The United States and Canada are both poised for a sharp economic rebound from the crisis of 2020, but the early signals suggest that their respective monetary policymakers will respond in different ways and along different timelines. In fact, even though the U.S. is ahead of Canada in emerging from the pandemic, it might well lag its northern neighbour on the path towards policy normalization. If so, the reasons might have to do less with different economic conditions between the two countries than with the emerging heterodoxy of the central banks on inflation.
Let us begin by looking at the Bank of Canada and note that it has very quickly become more buoyant about the economy over the next three years. In its latest Monetary Policy Report, released in April, the BoC upped its GDP growth estimate for 2021 to 6.5% (250 basis points, or bps, higher than in its January MPR), pulled forward some growth from 2022 (3.7%, down 110 bps), and raised its estimate for 2023 to 3.2% – a full 70 bps higher than in January.
The bank’s revised inflation expectations are even more illustrative. For 2021, it now expects CPI inflation to hit 2.3%, up from 1.6% projected in January; for 2022, its revised number is 1.9%, up from 1.7%; for 2023, it projects 2.3% inflation, up from 2.1%. In short, the bank is telling markets that it expects more growth and more inflation – averaging 2%-plus over the next three years – than it did just three months ago.
That is half the puzzle for the Bank of Canada. The other half is that it was extremely aggressive in its quantitative easing (QE) program last spring, purchasing C$5 billion in bonds a week, or approximately C$22 billion a month – a level that dwarfed the Fed’s US$120 billion-a-month QE program on a relative-size basis. Had the BoC continued on that path, it would have ended up owning 60% of Canadian government bonds by the end of this year. But it did not continue. Last fall, the bank – which has publicly stated it is uncomfortable holding more than 50% of the market – trimmed its QE purchases to C$4 billion a week; in April, it pared down to C$3 billion a week, a level that is approaching a standstill position relative to average weekly fiscal 2021-22 net issuance of about C$3.5 billion per the government’s current budget. As of April, the BoC owned 42% of the bond market.
Remember, the Bank of Canada has one – and only one – monetary policy mandate: to maintain inflation at or around its 2% target. With inflation expectations running above that, and with concerns over the level of intervention in the bond market, the BoC seems poised for a more hawkish response than it was at the start of the year. It has already begun tapering, and the market now projects a rate hike sometime in the second half of 2022 – six months earlier than it previously expected.
Compare that approach with the Federal Reserve, which has said it is not even thinking about tapering even though U.S. GDP growth is even stronger than Canada’s and inflation is undoubtedly running above the historical 2% target. Simply put, the Fed is just not as worried about inflation as the Bank of Canada is – or, rather, it is not worried only about inflation. Unlike the BoC, the Fed has a dual mandate: maintaining inflation around 2% and maximizing employment.
Next time: Why the U.S. Fed tolerates higher inflation...and Canada does not.
David Stonehouse, Senior Vice-President and Head of North American and Specialty Investments, AGF Investments Inc., is a regular contributor to AGF Perspectives.
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© 2021 by AGF Ltd. This article first appeared in AGF Perspectives. Reprinted with permission.
The views expressed in this blog are those of the author and do not necessarily represent the opinions of AGF, its subsidiaries or any of its affiliated companies, funds or investment strategies.
The commentaries contained herein are provided as a general source of information based on information available as of June 1, 2021, and should not be considered as investment advice or an offer or solicitations to buy and/or sell securities. Every effort has been made to ensure accuracy in these commentaries at the time of publication, however, accuracy cannot be guaranteed. Investors are expected to obtain professional investment advice.
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