The policy forwards are too skinny

Andrew Grantham: After that, you know, how quickly they cut, we don’t think they’re going to necessarily cut as quickly as we previously thought. We have a year-end target now of 375, but that’s still a lot more cuts-

Ian Pollick: Too high. Too high.

Andrew Grantham: (laughs) That’s still a lot more cuts than the market is pricing though, right? So…

Ian Pollick: Welcome back to another episode of Curve Your Enthusiasm. This week I am joined by the one and only Mr. Grantham. Andrew, how are you man?

Andrew Grantham: Good, how are you doing?

Ian Pollick: Not bad, you have not been on this show in a very long time.

Andrew Grantham: I know, I thought I offended you or something.

Ian Pollick: (laughs) Well, the show’s early, let’s see what happens. We have a lot to talk about. And so let’s just start off this episode by talking about some of the more nuanced macro themes happening right now. On the surface, things look, to me, which is a very interesting narrative. It’s early February, people have moved away from higher for longer, they’ve moved away from a soft landing, and now there’s discussions of a no landing, which is obviously kind of crazy, just given it so early on in the year, but I would be hard pressed and remiss not to talk about a very important theme, which is the degree of non-inflationary growth. This was something that tripped up economists, strategists, policy makers very early on in the pandemic. Remember that the supply side was gutted and so coming out of things in 2021, there was a lot of talk in the community about this non-inflationary growth and how supply side had to come back online. But obviously what we miscalculated was the demand portion of that. Right now we are seeing relatively good growth in Canada, which is not expected. Particularly after a year where we’ve had almost no growth at all. I want to pick your brain to start the episode about this idea of non-inflationary growth and how much low-hanging fruit there actually is in this economy.

Andrew Grantham: Yeah, and I think that’s a very important question as we think about when the Bank of Canada can start cutting interest rates, because as we sit here now, the facts that we have, and facts can change, particularly when they rely on Statistics Canada revisions, but the facts that we have today is that Q4 looks better than the Bank of Canada was expecting, only let’s say a month ago in their MPR. And the handoff to Q1 also seems a little bit better than we and the Bank of Canada were expecting. I do think looking into some of the details of some of the recent releases, such as the monthly GDP figures that we’ve had, there is a lot of this growth, or at least a lot of the upside surprise does seem to be coming from the supply side. Remember, we had the impacts of port strikes earlier in 2023, we had the impacts of wildfires, you know, we had a auto sector that was still trying to rebound and then we had the strike activity in the US. So we did have a lot of supply disruptions, you know, what we are seeing within the data is that yes growth does seem to be better than we and certainly the Bank of Canada were expecting. A lot of this does seem to be driven by, let’s say the manufacturing sector, for example. And there does seem to be more of this low hanging fruit available when we look at manufacturing capacity, for example, relative to its long-term averages. There are some sectors within the manufacturing activities that there is some low hanging fruit. They can raise production still as some of these supply issues fade. So some of that was used up in Q4, but I think some of that can continue into the first half of this year as well.

Ian Pollick: But let’s just talk about this for a second, right? The production function of the broader economy is always going to be subject to some underlying, you know, pace of demand or some tempo of demand. And so in the absence of this demand, because as you said, it’s not really showing up in the data, how much longer can we expect this kind of utilization to be increased?

Andrew Grantham: Yeah, so the demand that we’re filling with this increased utilization isn’t necessarily domestic demand, it’s our exports. Our exports have been running slower than the foreign activity index that the Bank of Canada would suggest. So it’s partly the fact that the US economy is strongest, a demand there, but also we’ve been running lower than this. Putting some figures together on kind of just how much capacity we still have. I think somewhere between half and one percent of GDP, if there were no supply issues, no further supply issues at all, GDP could be about half to one percent higher if we got rid of all of the supply issues and if we were able to produce foreign demand especially, is at the moment.

Ian Pollick: Are you talking about the growth rate or levels?

Andrew Grantham: I’m talking about the level of GDP. So that doesn’t have to happen in one quarter. But that could be spaced out over kind of two, three, four quarters. Now the big underlying assumption there is that there’s no further supply issues. We still have in Canada, a lot of unions debating, you know, with governments, with representatives, et cetera, you know, in terms of wage demands, et cetera. So the strike activity could continue on into 2024 in certain sectors. But if there were no supply issues at the moment, if we were able to raise supply to meet that demand, that global demand, then about half to 1% of GDP, that is the impact at the moment.

Ian Pollick: Okay, so let’s just extend this little bit because you know, the Bank of Canada is actually pretty good at its near term forecasting. And so when you get a miss this big, obviously something is happening and that’s what we’re talking about right now. But you have to come back to this idea that what we’re looking at is production data and the quarterly GDP figures are expenditure data. And so can you just walk us through this normal slippage and how you think this may be any different? Like when we get to the quarterly numbers, maybe we’re not actually that different from zero because that slippage has gotten larger.

Andrew Grantham: And that’s why I said facts can change because they certainly can when it comes to Stats Can and their revisions. And we’ve had, the last couple of quarters, we’ve had some big changes between the production and the expenditure data. So it’s still quite possible that the Bank of Canada is right and there was zero growth at the end of last year. But we’re kind of hedging our bets somewhere in between what the Stats Can data today show, the production data, and what the Bank of Canada was forecasting. So we’re forecasting about a 0.8% growth in Q4. So a little bit weaker than the production data, but that will still be stronger than the Bank of Canada’s assumption.

Ian Pollick: Yeah, and that would actually give a handoff that’s basically flat to the bank’s current assumption for Q1 as well. So, I mean, you have this growth impulse that may or may not be real per se, or at least not as strong as the monthly data says, but it’s not inflationary is the point, right? At least not now. And so within the context of, and let’s just wrap this topic up. If you’re right and you have this increase in capacity utilization, and let’s say you’re around that 0.8 for Q1. How does that change the bank’s output gap math?

Andrew Grantham: It shouldn’t. That’s the point. Now, whether they agree with this supply, the supply dynamics driving the upside surprise or not is another matter. But if it is driven by an improvement in supply, it shouldn’t change what they think of the output gap. And in Q1, we’re still talking about a growth rate, which is below potential given how strongly the population and the labor force is growing. So, you know, we’re still talking about an output gap that would be widening, a negative output gap that would be widening. But, you know, adjusting for some of that supply driven growth, I don’t think they have to necessarily adjust what their starting point assumption was for Q4.

Ian Pollick: Okay, so there’s no huge innovations here. And that’s important, but I want to pick up something that you just said. You know, let’s just talk about the labor market here. Because again, you know, to me, we talked about growth and the macro story, but there’s some undercurrents that look a bit complex. And I think you can say the same thing for the labor market right now. You know, you’ve just gone through a data cycle where US non-farms beat expectations, Canadian jobs beat expectations. Is there something happening beneath the surface here?

Andrew Grantham: Yeah, I mean, in terms of the US numbers, you know, the big thing with the US numbers was the fact that we did seem to have some weather disruption there, which negatively impacted hours, positively skewed up wages, you know, when you do have those weather disruptions, it’s generally the lower paid workers who can’t get to their jobs, so they don’t get paid during that week. And so you do get that skew of lower hours, higher wages, which I think will be balanced in the next month. Canada is very, very interesting because we’ve talked before on this podcast about the Bank of Canada maybe not openly admitting to it, but they seem to be using the unemployment rate as a guide in terms of where they think the output gap is because they’ve kind of lost faith a little bit with the output gap measure because as we’ve talked about, there’s been supply driven factors as well as demand driven factors over the last few years. What was interesting obviously within the labor market report for Canada was that the unemployment rate actually came down a little bit. But when I look at that, it was really driven by a decline in participation. And again, we’ve talked on this podcast before, my preferred measure of unemployment rate, particularly for Canada where there’s a lot of short-term unemployment because there’s a lot of seasonal jobs much more than there are in the US. My preferred measure of unemployment in Canada is the unemployment rate for people who have been unemployed for three months or longer because it gets rid of a lot of that short-term unemployment. That is still rising. So that tells me that the people who are staying in the labor market, who haven’t dropped out, are still finding it much harder to get jobs than they were doing.

Ian Pollick: Well, it’s interesting because I was looking at some of the data from the last LFS report. And one of the things I saw was if you look at private paid full time employment, it’s had back to back consecutive declines. And this is actually pretty rare in the data. Like this has happened several times in the past kind of seven years. Usually you get a decent bounce back the next month. But is there some indication to you that the underlying momentum of the labor market is a bit slower than policymakers think? And I would say that too for the US because after those revisions, what we saw was in 2023, you know, 90% of job creation was actually part-time jobs.

Andrew Grantham: Yeah, and I think that there definitely is, particularly for Canada. We have seen, it’s not just the last two months, we’ve seen pretty consistently over the last one or two years actually that public sector employment has outpaced quite significantly private sector. Private sector employment has not kept pace with population growth. So, if we hadn’t had that big surge in public sector jobs, the unemployment rate today, if the public sector employment had only just matched population, we would be at an unemployment rate of around six and a half percent right now. But we’re not. So there’s definitely some underlying weakness there. And you can see that when you look at the job vacancy rates, which have come down pretty significantly, and I would say more so in Canada than in the US even.

Ian Pollick: So riddle me this, I was at an event a couple weeks ago and ex-Bank of Canada Governor Poloz was speaking and he was asked about wages. And he said that he thinks some of the move higher in wages or at least the level of wages that’s above trend is a function of retirees. And so his whole premise was like, look, you are in this environment where you have baby boomers retiring. And if you look at supervisory and managerial positions in Canada, the growth rate of that cohort of the labor market is growing much faster than other parts. And so he premised this idea that you have companies that are onboarding some of these supervisors and managers maybe a year in advance of the person currently in their seat about to leave. And therefore the wage pie is being biased higher. I couldn’t really see it in the data and you know, managerial supervisory positions are only about 10% of employment. Do you put any credence into that?

Andrew Grantham: I mean, it’s possible. For me, the bigger factor at the moment, which may be skewing the wage data a little bit higher is just the compositional impact. You know, we’re starting to see the weakness in consumer spending is impacting hiring decisions in areas like retail sales, in areas such as hospitality. Even in construction, it’s not necessarily the supervisors, it’s the lower paid people who are let go first. And that skews up the average wage. So your wage growth looks higher. So the supervisory issue and the ageing population could be part of it. I think a bigger part of the reason why wage growth looks stronger than it probably is right now is composition within sectors.

Ian Pollick: Yeah, I would agree with that. And I think that’s a big deal, right? Because by definition, that’s not necessarily an impulse, right? And it’s not structural. It is just a compositional story.

Andrew Grantham: No, and you see this every time you are entering either a slowdown or recession, that wage growth, at least the unweighted ones that we typically view, often accelerates first because you always see this. It’s always the lower wage people who get let go first, or at least hiring in those areas, slows down first. So this is very typical of a slowdown or, if you do think we’re falling into a recession, the start of a recession.

Ian Pollick: Yeah, so the silhouette is familiar. OK, I like that.

Andrew Grantham: So, you know, in turn, we’ve talked a lot about kind of what’s been going to be driving policy decisions when we start cutting interest rates, but we did have announced earlier this week that there’s going to be a speech about QT in Canada in mid-March. What do you think that’s going to tell us about kind of the wind down of that, and does this, the timing of the speech, tell us anything about when this may begin?

Ian Pollick: That’s a great question, Andrew. And obviously there’s been a lot of focus on quantitative tightening in Canada, particularly just given some of the moves that we’ve seen in overnight repo rates, like CORRA relative to the target rate. And you know, last week on our episode, Jeremy and I talked a lot about CORRA and we kind of joked that there’s 11 people listening to this podcast that may find this interesting. Actually, it turns out there’s a lot more than 11 people. You know, we got a lot of messages after the fact. And so, let’s just talk about this a little bit. What’s the issue here? The issue here is that Canada is now operating in the system with an arbitrary large amount of non-borrowed excess reserves. And those excess reserves are really meant to keep overnight rates close to the floor. And if you remember that, prior to the Bank of Canada using this floor system pre-pandemic, banks had effectively had a call option. And then that call option was allowing them to borrow all the reserves they needed in real time, assuming that they were short liquidity at a known rate that marked the ceiling of that corridor. And that was the bank rate. And so the question is, if QT ends, and if it ends in March or if it ends in April, do we care? And of course we care, you know, not only because of what it means for CORRA, which I’ll get to in a minute, but I actually think there’s also some real macro economic impacts. And so, you know, most of the research about unconventional policies like QE and QT, they’ve really mostly been about, you know, the impact on the interest rate channel. And so in plain English, that just means that researchers have really focused on the stimulative impact of bond purchases just through the compression of those longer dated yields and as longer dated yields fall that reinforces riskier asset returns. And so that’s the portfolio diversification effect. But what’s interesting is that most people totally ignore that alongside these bond purchases, you have this massive injection of very long term and very persistent liquidity. And that is a secondary result of these unconventional policies. And so for Canada, I think we really do need to start thinking about how the secondary impact transfers back into the real economy. And so if anything, I think that the injection did help the Canadian banking sector fend off a deeper deleveraging event that a growing liquidity deficit probably would have underwritten. And so I think to that end, this notion of secondary liquidity on the back of bond purchases, what it implicitly means is that you do have some real support for the real economy. And the bottom line is that when reserves were plentiful, the banking system minimized their liquidity surplus by creating credits and claims on those surplus reserves. And that was all in an effort to kind of offset NIM contraction. But in a world where you’ve had reserves falling and now likely to plateau at a relatively high level, I think it’s completely insane to ignore how the system converges to this kind of lower liquidity environment because you can’t ignore those initial conditions. And so we are going to get a speech from Deputy Governor Gravelle on the 21st of March. Number one is that remember the Bank of Canada’s meeting in March is on the 6th. So it suggests to me that we’re not going to get a formal announcement at the March meeting. Rather, we’re going to get some updated guidance on the 21st. And also this is the first time in almost exactly a year that we’ve heard from Deputy Governor Gravelle on the topic of QT. The last time he spoke in March 2023, there was two things that were said that stuck out to me, actually three. The first was that in trying to decide when to end quantitative tightening, the bank was looking at its optimal level or ample level of reserves. And that was between 20 billion to 60 billion. Number two, they said, well, barring the ability to reach that level of reserves, another signal for them to end QT would be persistent deviations in core relative to target. Now they never gave a numerical number, but we always assumed it was on that five basis points number. And indeed we’ve seen them try to protect that five basis point differential pretty aggressively through overnight repo operations, the announcement of the receiver general auctions. And so I just think we’re going to get some updated signals from him as to when QT will be formally wound down. We still think that it happens officially at the April meeting, but for all intents and purposes, I think that the updated guidance provided in March really starts to signal the start of the disillusion of the QT program. You know, I don’t think though that core does all that much on the back of this. We’ve already seen a bit of stability around that kind of four basis point deviation level. I think what’s more interesting though is what happened the day after QT and that third thing that Deputy Governor Gravelle kind of signaled in his speech last year was when the bank stops shrinking its balance sheet, it will start to buy bonds again in the primary market. And that’s just a function of the growth of the liability side of the balance sheet, which is predominantly currency and circulation. And that grows at about 5% a year, and there’s about 120 billion outstanding, right? And so, it’s not a small number, but it’s not insignificant. I think something else though is really important. And we put out a piece a few days ago talking about this. When you just look at the amount of maturities on the Bank of Canada and his balance sheet, let’s say for the coming fiscal year. And even in a very conservative view of gross issuance from the federal government, which we think is about 250 billion next year as well. If the bank were to revert back to its normal 13% purchases at auction, it would not be enough to restrict the balance sheet from falling. And so that means that ending QT and not changing tact, actually creates this QT light situation. And nobody wants that, just given some of the upward pressure we’ve seen on core to begin with. And so I think what’s going to happen is we now have to really start thinking about the Bank of Canada buying bonds in the secondary market again. And in addition to using other tools like term repos to help manage that runoff, but I do think now that you’ll get this kind of three-fold approach where they’ll buy bonds in the primary market, they’re going to buy bonds in the secondary market from the stock of bonds of which they do not own. And that’s actually pretty meaningful. You know, there’s about 40% of the bond market that they don’t own because the growth of supply has exceeded the decline in QT. And so the relative growth rates do matter. And third, I think they just utilize term repos to help manage that as well. But you know, from your perspective, from a macro economist, do you care much about QT? Like it’s a big deal for me, but I don’t know, do you care?

Andrew Grantham: I care a little bit more now after listening to that to be perfectly honest because you know, and we’ve talked about this before, we’ve talked about the impact that QE or QT has had on kind of longer term bond yields and we’ve discussed that it’s probably fairly small and you know, maybe not a big macro impact but you know, if we do get some of those secondary impacts that you’re talking about, that could potentially even be bigger than any kind of change in those longer term bond yields in terms of the potential macro impact.

Ian Pollick: I think so. And I think it’s actually really important when we think about the overall demand of liquidity from the banking system as you go into some of these big mortgage renewal years in 2025 and 2026. But let’s just switch tack a little bit. And I want to very quickly, before we wrap this up, two more topics. The second last topic is US CPI. Obviously we saw this kind of upside surprise post the revisions, a lot of the ex ex measures like super core accelerated, but I don’t care so much about that. What I care about is how this feeds into core PCE. And so maybe walk me through how you’re thinking about core PCE, the progress and disinflation, and ultimately, you know, let’s discuss healthcare costs as well and how that feeds into this.

Andrew Grantham: Yeah, and I think this is something we disagreed slightly about earlier in the week. But I was actually a little bit surprised, not by the initial reaction to CPI, because obviously it was a lot higher than people were expecting. What I was kind of surprised about was the fact that the reaction continued throughout the morning, right? Like when I look through some of the details and particularly the fact that shelter costs were such a big driver of core CPI, which everyone knows is weighted differently, weighted lower in PCE. I wasn’t quite as concerned about that upside surprise. And I know we saw that medical service costs in CPI were on the strong side, but really the correlation between medical service costs in CPI and PCE is not great. And what we tend to see with the PCE prices because they are not just out of pocket, but they’re also employee healthcare provided, Medicare, Medicaid, it is weighted more, but it brings in more things that, the PCE medical care service numbers tend to be a little bit more stable. They don’t see the big declines that CPI has, but they also don’t seem to see the big monthly increases either. So from our point of view, our base case when it comes to core PCE is a 0.3. That would still be higher than the recent trends. So it would still mean a little bit of a step back in terms of the disinflation narrative, but maybe not quite as big of a step back as CPI saw.

Ian Pollick: Okay, and let’s talk about Canada. I mean, obviously there’s this huge amount of discussion around the Bank of Canada starting to pivot people’s attention away from some of the newish core measures that were introduced in 2017. And so, I wouldn’t go as far to say that the bank is going to make a brand new gauge of inflation nor will they touch the target, but there is some evidence, at least from my perspective, that they are putting a little more attention on CPI-ex, which is a world that they understand, as well as kind of core ex-shelter numbers. Do you think this is something bigger or are we just kind of overthinking it?

Andrew Grantham: It’s about time is all I can say. Like we’ve talked before about these core measures, trim and median. There’s a very strong correlation between those measures and things like food prices, because food prices, you can’t trim all of that out. So if food prices are rising, trim and median tends to be rising as well. I don’t think that those are necessarily as good an indication of underlying inflationary pressures as the Bank of Canada thinks. They do seem to be slowly recognizing that there may be some issues with those trim and medians, and they’re moving away, or they’re moving towards, or at least bringing in some other measures in their communication. But you talk about CPI ex-shelter. If they are moving towards that as a sign that, hey, inflation is under control, apart from the shelter costs, we can’t do anything about that because that’s a supply issue because of population growth, because we’re not building enough houses. You know, CPI ex-shelter has really been in a 2% inflation world since last May or June. Like we have seen only one month above 3% year over year since then. So, you know, we are back already to a 2% inflation world if they are going to start relying on that ex-shelter measure.

Ian Pollick: Okay, and so obviously that would be a catalyst for markets to reprice themselves a little bit because as it stands right now, it’s like, I don’t know when the policy forward started to take Ozempic, but they look awfully skinny to me. Like for context, at time of we’re doing this podcast, you have three cuts, basically a little under three cuts this year for the Bank of Canada, four cuts for the Fed this year, and three cuts for both central banks next year. This feels pretty light and not just because of magnitude, but also relative to where inflation expectations are, because that’s just another way to say that, you know, we started the year with this idea that as inflation falls, real policy rates start to rise. So you have these adjustment cuts that were being introduced. But now you basically have almost no adjustment to real policy rates over these forecasted horizons. And there’s almost absolutely no room for error in terms of the economy actually needing stimulus at some point. Now, even though that’s not our forecast, there’s no probability in this path. And so tie this all together for me. What do you think when you see what the repricing event has been? Remind us of your Bank of Canada forecast, your Fed forecast, and what you think of this.

Andrew Grantham: So it’s crazy. I mean, you start the year and we were basically saying that the markets have been too aggressive, particularly in the timing of the first cut for the US and Canada. And now, if anything, for Canada, we’re kind of the other way around. You know, we haven’t changed our Bank of Canada forecast, at least in terms of the timing of any rate cuts since the start of the year. We still see June as the first move. And I think by that time, you will see inflation low enough. You will see growth maybe to start Q2 is weakening again after some of this supply-driven growth that we’ve seen in Q4 and Q1 has been used up. And I think by that time, the Bank of Canada will at least feel more comfortable in terms of cutting. After that, you know, how quickly they cut, we don’t think they’re going to necessarily cut as quickly as we previously thought. We have a year-end target now of 375, but that’s still a lot more cuts-

Ian Pollick: Too high. Too high.

Andrew Grantham: (laughs) That’s still a lot more cuts than the market is pricing though, right? So it’s, you know, when they start, if the economy doesn’t suddenly re-accelerate or we suddenly see a spike in inflation, they will continue to cut interest rates gradually towards neutral. Whereas in the US, I think, we’re a little bit more comfortable now with market pricing in terms of the magnitude of cuts. I was worried at the start of the year that if the Fed was tempted to start cutting either too early or too aggressively, that they could reignite inflation because really the US economy hasn’t slowed down too much. Retail sales recently were below expectations, but we were coming off a very strong Q4. The level of consumer spending is still very elevated in the US. So, I was worried about that temptation if inflation kept falling, that the US could cut too early or too quickly and then reignite inflation in the second half of this year. The fact that the Fed has kind of pushed back against that, the fact we’ve had this upside surprise in CPI, that temptation is probably no longer there. So we still expect cuts to start in the second half of the year.

Ian Pollick: I still think you have one too many cuts for the Bank of Canada this year. I think 100 is probably the right number. No problem in terms of the timing. It’s just more the forward distribution. What’s interesting is that in this latest round of repricing, it’s very different because we’ve had periods in the past six months where we have taken out near term cuts, but we’ve always redistributed them back somewhere in the next two years. Here you are just taking cuts out and you are not replacing them. And that’s a very different story. And so that is one where, as we started off the show, it’s just kind of this strange idea that there’s just a flyby. There’s not even a landing. And, you know, again, I remind everyone it is, you know, early February. And so it’s pretty crazy to me for this to happen. Anyways, we’ve talked a lot. Thank you for being on the episode. To all of our listeners, I hope you have a great weekend ahead. And remember, there are no bonds harmed in the making of this podcast.

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