Well that was anticlimactic

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Andrew Grantham: We saw a cooling in consumer spending even at that 1.75 level. And you know, if anything, households have taken on more debt and have become even more sensitive to higher interest rates, to interest rate increases in Canada relative to the US.

Ian Pollick: Ok, so we have some fresh blood in the studio today. Andrew Grantham, Senior Economist at CIBC Economics, is joining us today. Andrew, how are you?

Andrew Grantham: Good, thanks. How are you doing?

Ian Pollick: I’m good, man. Listen, let’s jump into this because we obviously have a lot to talk about. And I think the obvious starting point is the Bank of Canada from two days ago. So we know the Bank of Canada raised rates, largely expected. When you read the statement, was there anything that stood out to you?

Andrew Grantham: It was all pretty much as expected. You know, the Bank of Canada, when they are raising interest rates, they have to sound positive. They have to provide a justification for that rate increase. So, you know, they talked about the upside surprise that we saw to growth. They talked about inflation, of course. I guess the one thing that slightly surprised me, particularly given some comments that we saw coming out of finance the day before, is that when it came to this new uncertainty coming out of Europe, coming out of the Ukraine, it was listed. But, you know, very kind of small paragraph in terms of that new renewed uncertainty and certainly more focus when it comes to that seems to be on inflation and potentially dislodging inflation expectations rather than necessarily at this stage, any kind of downside risk to growth. But you know, as I said, as I mentioned earlier, they had to be, you know, fairly positive to justify the fact that they were moving interest rates higher.

Ian Pollick: Yeah, I mean, one of the things that struck me yesterday was the amount of comments they got about how hawkish the statement was. But to your point, you know, this statement is designed as a justification for why they hiked rates. They’re telling people why they just hiked. So, you know, from my perspective, it’s hard for them to sound dovish. Would you agree with that?

Andrew Grantham: I would. Yeah, they had to justify that rate hike. And also, you know, this was not an MPR meeting. They don’t have their full forecasts. And you know, if the Bank of Canada is anything like us trying to figure out events in Europe, the impact that that could have on growth and in particular inflation, you know, their forecasts are probably changing on a daily or at least, you know, every other couple of days basis at the moment. So, you know, without that MPR, without that full forecast review to talk about that in more detail, you know, I think what they did in terms of mentioning it, but not going into too much detail there, was justifiable and you know, they did have to be positive in order to justify the rate hike. Now I saw that you put out something just after the hike. You know, there are some kind of, you know, technical adjustments that they’re making, which is maybe different in this hiking cycle than we’ve had in the past. You want to touch on that?

Ian Pollick: Yeah, sure. I mean, remember that after the bank hiked rates, they sent out this note talking about how they would help to guide short rates to actually reach the target rate within the floor system. And remember, that floor system is very similar to what we see in the United States. And prior to the pandemic, Canada operated in what was known as a corridor system, meaning that you had your bank rate, which was twenty five basis points above your target rate and you had your deposit rate, which was twenty five basis points below your target rate. The reason why you had that 50 basis point range was really a penalization function for the payment system. Because in Canada, monetary policy is transmitted through the payment system. So in normal times, when the LVTS isn’t net long like it is today, those who needed money would be incentivized to lend to each other rather than going to the bank, and those that had excess cash would do the same. You know, the problem is, is that because the balance sheet is so elevated because there’s so many excess settlement balances, you’ve seen this persistent dislocation in overnight repo rates, which is really the transactional target rate in Canada. And in order to ensure that you are in an environment where you could be reasonably confident that you didn’t get too much slippage in the tightening cycle, the bank introduced this overnight repo rate operation that will be set at the high end of the range, i.e. at the target rate. And against that, you have the subfloor, which is your SRO, which is a securities repo operations and that’s set at 40 basis points. So between the two of them, the bank’s basically saying, you know, you could source all the collateral you need. You can lend money at 50 basis points. If you have to go borrow securities because you need them, you can do it at 40 basis points. You know, it’s highly technical, it’s a little bit dense, but what it really does is it tries to uplift the transactional level of the target rate, which is CORRA.

Andrew Grantham: Ok. And you mentioned at the start of that, you know, this is something because of how elevated the balance sheet is at the moment. When QT starts, whenever that may be now, when the balance sheets, you know, starts to come down a little bit. Do you have any idea about how long they’re going to still need to be doing this, given the size of the balance sheet and how quickly or slowly, I guess the balance sheet may shrink when they do start that process?

Ian Pollick: Yeah, for sure. I mean, you know, just to take a step back there. Our house call was for QT to start in April, but I did think we would have gotten some more colour from the statement itself. Obviously, we didn’t. So we do think that it starts. It gets announced at the April meeting and in between then I do believe we’ll get some more guiding principles about the level of the balance sheet and what that normalization looks like. But the question is, and it’s an interesting one, is how does that interaction work, where you’re actively shrinking settlement balances while at the same time promoting that subfloor? I think they’re complementary. The irony isn’t lost anyone that right after the bank raised rates, the SRO operation failed for technical reasons. Now, we don’t know if that’s because changing point one five to point four blew up the code. I suspect it’s not that simple, but you know, there’s frictions, and I think it’s just growing pains in a system that isn’t used to having so much cash. You know, there’s some market implications that we can get to that in a moment, but I want to touch on something that you brought up earlier. And it was this idea that in the statement two days ago, you know, what they actually said was the unprovoked invasion of Ukraine by Russia is a major new source of uncertainty. Is it fair to believe that that major source of uncertainty isn’t just a negative, that it could actually be symmetric and somewhat positive?

Andrew Grantham: Well, for sure. You know, if there’s going to be, you know, negative implications, you know, it’s obviously going to be for Europe first and foremost and mostly in terms of magnitude. For Canada, you know, what we have at the moment is higher commodity prices, not just oil, but you know, grains as well that we’re seeing which, you know, will be a positive for the Canadian economy. You know, longer term, if they persist, which, you know, we don’t expect, you know, oil prices at this level to persist for too long after this war, and hopefully this happens soon after it is over. One thing that will persist, though, is Russia is going to be much more cut off from the western world. You know, after this is all over and again, you know, we hopefully hope this is all over soon with, you know, as little loss of life as possible. But you know, that’s really the implication longer term that we have to think about, you know, we have, you know, this near-term spike in commodity prices, to the extent that people don’t expect that spike in commodity prices to last, it’s not as big a positive for the Canadian economy as otherwise would be. You have increases in corporate profits, you have increases in government revenues, which will later on potentially feed through into spending. But we’re certainly not get in. And, you know, also with the kind of the shift to greener energy going on worldwide, we’re certainly not going to get the big shift in terms of investment in the oil sector that we were seeing when we had commodity prices at these levels back in 2013 2014. So, you know, for the Canadian economy, you know, the near-term, the inflation hit is going to have an impact, I think, on consumers. We’re not quite as optimistic as others in terms of our growth forecast for consumer spending because we don’t necessarily think that consumers in Canada have the savings cushion behind them that many others do because, you know, people weren’t spending during the pandemic in normal means. But a lot of that money was getting filtered through into the housing market. So you look at bank deposits, those savings that people have built up, they are still there. They are still excessive compared to where they were before the pandemic.

Ian Pollick: But they’re incrementally as effective because as inflation rises, you’re still reducing that net stock, right?

Andrew Grantham: Yes, it’s still provides a cushion for the increase in inflation. I’m just not sure it’s as big a cushion as maybe other people suspect. You know, given you know, these estimates of excess savings of $300 billion that we see floated around based on the GDP figures. You know, looking at the bank deposit figures, we put that, you know, more on the kind of the 80 billion mark. So still a cushion, but not as big a cushion, you know?

Ian Pollick: So I think that’s an interesting angle that I just want to talk a little bit more about because on the one hand, you see one hundred and fifteen dollar oil, obviously, that must be amazing for Canada. The currency isn’t moving. We’re not seeing the same type of labour investment. We’re not seeing the type of business investment or capital deepening. So is it fair to say that one hundred dollar oil in 2022 does not have the same impact as hundred dollar oil in 2015?

Andrew Grantham: Yeah, that’s perfectly fair because we’re not seeing that same level of investment in the oil sector. There are still positives, as I mentioned, through corporate profits, through government revenues, and I think we’ll talk a bit later about Alberta and their budget and that sort of thing. But yeah, it’s definitely not as big a positive as it once was. And also because, you know, you look at all futures, you know, people aren’t betting companies aren’t betting that these very elevated oil prices, which have that risk premium of the war that’s happening in the Ukraine built into them, they’re not expecting those to persist as well.

Ian Pollick: Ok, so let’s just talk about some of our forecasts because, you know, you kind of mentioned forecast variability in the banks probably redoing their forecasts a bit quicker pace than they’re used to. And so are we in all honesty and you know, obviously, I want to talk about the CPI forecast, because we have the move in energy prices, I know we’re restricting our expectations for the near term. So let’s just walk through our listeners what we’re thinking in terms of, let’s say, Q1 average relative to what we were a week ago and how that compares to the bank.

Andrew Grantham: Yes. I mean, the bank, you know, back in January, they released, I think the Q1 average was five point one. You can correct me if I’m wrong, but it was slightly above five, I think.

Ian Pollick: No, that’s right. That’s right.

Andrew Grantham: At the time, you know, we were looking at that forecast because that would be based off oil prices at the time, which were seventy, seventy five dollars. Let’s say something around that area, and we were looking at that forecast and thinking, man, that looks high, like, how were we going to reach that average?

Ian Pollick: I know. I remember having that conversation like, it has to average five tenths every month. How’s that going to happen?

Andrew Grantham: Yeah. And then suddenly now we’re looking at new forecasts, and I have some provisional forecasts from two days ago here, which is an average of five point five for Q1. And that was based off oil prices, which are kind of, you know, $10 lower than they are today. I think, you know, this is something that’s moving very quickly, obviously, particularly with the near term forecasts and what’s happening with commodity prices. The one thing that I do want to mention when it comes to inflation, though, and you know, this goes back to the GDP figures, not just in Canada, but also the U.S. as well. You know what was driving inflation before this war erupted in the Ukraine, it was food prices. Still, it was energy prices, but it was also goods prices, right? The excess spending on goods, particularly in the U.S., not so much in Canada, but in the U.S., but also the supply shortages as well, the supply chain delays. Now what we have seen in the U.S. numbers recently is that restocking has taken place or has started at least. It’s not fully finished, but those inventory levels aren’t anywhere near as stretched as they were. So I think what we will see over the next few months is, yes, our inflation forecasts are going to be a lot higher than we were previously expecting due to what’s happening in Europe and the impact that that has had on energy prices and food prices. But I do think some of these kind of core metrics which pick up the goods price inflation, strip out what’s happening in energy, I think they will start to decelerate. We are seeing some underlying improvement in some of these areas that were driving that very strong inflation. That’s just going to be clouded by what we’re now seeing in energy markets and in food prices.

Ian Pollick: Well, it’s interesting. You know, against that backdrop, if you look at the statement yesterday, the bank said that prices are becoming more pervasive and they had hinted at that in January. But now that’s gospel. It’s in the narrative. And I think the concern here is that obviously we’ve talked about Ukraine being the breadbasket of Europe that has a global impact on food prices and food price inflation is real regardless of where you are. And you know, that’s one of those persistent, very sticky components of the basket and that can un-anchor expectations. And so, you know, let’s just overlay this with the growth outlook. We got the growth numbers earlier this week. Q4 growth was a full percentage point above the bank’s estimate. Talk me through some of the components that you saw that give you pause for concern.

Andrew Grantham: Yeah, I mean, that’s when you get a six point seven growth forecast, there’s not necessarily too much to be concerned about, right? You know, six point seven is strong. You’d have to be the most pessimistic economist in the world to pick too many holes in that. But you know, the one thing I would say, what was driving that increase is, you know, if you rewind back to January’s MPR, January statement from the Bank of Canada, what they mentioned at that time is that they thought the output gap had closed. But, you know, there was some creative accounting in that to come up with that because what they said is that the near-term supply constraints which were dampening in supply had actually grown in Q4 rather than shrunk. Now I think what the GDP figures showed is that there was an inventory rebuild that had started. So I do think the near-term supply constraints actually eased in Q4. So you know what that means for the Bank of Canada is that, yes, they can still say the output gap is closed, but they don’t necessarily need to say that domestic demand is any better, any stronger than what they expected in their January MPR. So they don’t necessarily have to say that they now have a positive output gap, right?

Ian Pollick: Well, exactly. And you can see that in the final domestic demand numbers, right? And you know, even in the statement yesterday, they said something about it confirms their view that slack has been absorbed. It’s not like saying, oh, we see the number, here’s what that number is, and they just said it confirms a view, right?

Andrew Grantham: Exactly, exactly. So it confirms their view that slack was absorbed. But it doesn’t necessarily mean even though it was almost one percent above what their January MPR forecast was, it doesn’t necessarily mean that they are behind the curve when it comes to hike in interest rates and inflationary pressures.

Ian Pollick: Well, exactly because that creative accounting basically for our listeners. Just a quick throw back here, is they basically said if there’s any part of the supply side economy that’s impacted by supply chain disruptions, they’re removing it from the calculation. So as you get reduced supply pressures, you know, implicitly your supply side grows and therefore, you know, there could be some convexity in the output gap. That’s fair to say, yeah?

Andrew Grantham: Yeah, it is. Yeah, where we are now, even though the number, the actual number was above their forecast, that doesn’t necessarily mean that there’s any more or less slack in the economy than they had before. It’s just due to some of those supply chain issues, some of that impact on potential growth being probably low in Q4 than they’d actually anticipated at the time of that January MPR.

Ian Pollick: Ok, so let’s air a little bit of dirty laundry here buddy, because you and I, we pretty, pretty much often agree. But I think one of the things that you and I are breaking on right now, not by a huge extent, is this idea of where the Bank of Canada is going to end up. And not necessarily what the neutral rate is, but it’s more the terminal interest rate expectation for this cycle. You know, I know you wrote a paper about it. You and Benjamin Tal, great paper, as always. I want you to briefly describe what the paper is about, and I’ll preface that by saying that it’s not necessarily that I disagree with your conclusion. It’s more that I think there’s more stickiness in the perception on a relative basis that the current level of the terminal rate trading in the market doesn’t necessarily need to come down. And I very much subscribe to this productivity issue that Macklem talked about. You kind of justified it earlier, FYI, when you talked about the lack of investment. But you know, maybe I’ll just take a step back and just tell us what this paper is about and how you’re viewing this subject.

Andrew Grantham: Yeah. So I mean, the starting point for this paper was really, you know, we noticed that, and you can correct me if I’m wrong on what the market is doing these days because a lot has changed in the last week since we since we put out that paper. But really the starting point was that, you know, markets were pricing in a higher terminal rate in Canada than the U.S. and you know where the terminal rate was priced, and I think it was just over two percent, maybe in Canada at the time we looked at it. You know, we don’t have too many qualms about that actually, we think that’s, you know, fairly accurate. What we disagreed with, with the market pricing is why would the U.S. be priced lower than that, given what has changed over the pandemic? Because we know that in the last cycle, the Bank of Canada’s overnight rate topped out at one point seventy five percent. A lot of that, you know, topping out quite low and below where people thought the neutral rate was, was due to household sensitivity to higher interest rates. We saw a cooling in consumer spending even at that 1.75 level. And you know, if anything, households have taken on more debt and have become even more sensitive to higher interest rates to interest rate increases in Canada relative to the US during the pandemic. So, you know, that was really the starting point. And the one thing that I would say on productivity is like, yes, you do have weaker productivity in Canada relative to the U.S., but we’ve had that for 20 years, 30 years maybe. It’s, you know, we’ve been lagging on productivity for a long time. So you know, that divergence in productivity should have been built into where the terminal rate was in the prior cycle already. And you know, the US did manage to top out. I think it was between two and a quarter and two and a half in the U.S., which was above where we were. So that was kind of the premise for looking at that. It’s not to say that productivity doesn’t matter, but in a sense, you know, that should have been factored into where interest rates managed to go in the prior cycle. It hasn’t really grown as an importance in this cycle. What has grown is the debt that households have taken on in Canada and how sensitive Canadian households will be to those higher interest rates.

Ian Pollick: I mean, I don’t disagree, and I think this is a very ivory tower discussion. It’s a very secularly fundamental. You know, I tend to think of it more from a market practitioner’s perspective. And to me, I could say, do I believe that two and a quarter terminal rate being priced makes sense by itself? Yeah, yeah. Sure. Why not? Does it make a ton of sense on a relative basis? Probably a little bit less. But that’s really the theme, isn’t it? Remember that in 2021, you know, we had the Bank of Canada price to hike rates very early on this year, and people thought that was nuts, and we were of the opinion, actually, you know what, we think it’s the U.S. pricing that’s wrong. You know, it took a while for it to happen, but everything converged. And I think this is a similar story where, you know, I think if we do this podcast and you come back on, this was six months from now, it’ll probably be a bit of a different profile. But I think the market participants are basically saying, look, average inflation targeting means the Fed on average goes slow. Number two is that maybe quantitative tightening in the U.S. is seen as a much more supplementary policy tool than people are looking at it in Canada, and even yesterday, the bank said, you know, the overnight rate is the primary tool. I suspect you’ll get that same messaging from the Fed and maybe that prices itself out. But look, we’ve gone for a while. We’ve talked about a lot of good stuff. The last thing I want to talk about and let’s be really quick about this is the provincial economic outlook. We’ve had a couple of budgets. They’ve been quite solid, particularly with Alberta now in surplus, and that surplus has been achieved with even significantly lower expectations for oil prices. We put out a bunch of stuff on what we think the market implication is, but why don’t you just talk us through really quickly how you’re thinking about the provincial outlook right now, are you enthusiastic about it or are you concerned about it?

Andrew Grantham: Yeah, I mean, I think, you know, some of the things that we talked about the last discussion there on the terminal, the leveraged to higher interest rates. You know, that is more a story for Ontario and some of the other provinces that you’ve seen kind of these really big increases in house prices and increase in leverage for a while. And you know, when you talk about the positives from higher oil prices that we are seeing and the higher crop prices as well, you know, that really benefits kind of central and western Canada, right? So you know, that’s how we’re thinking about our forecast at the moment. If and when we do change them, we’ll be probably raising central western Canada a little bit and maybe taking that out of Ontario, maybe even a province such as Quebec. You know, you mentioned the Alberta budget there. They’re already in a surplus position. You know, that was seen a seventy or seventy two dollars oil prices for the coming year, right? And their upside projection, their positive outlook was based off eighty five dollars oil. And what that meant for a phenomenal GDP growth, which would mean, you know, an extra almost six billion in terms of revenue. And obviously, we’re way above even their upside now. So, you know, there’s definitely some, you know, improvements come there. The thing I will mention just briefly on the B.C. budget, because I think when you talk about spreads, you know, a little bit after me, people were a little bit shocked, I guess maybe is a bit too harsh a word, but surprised by, you know, the size of the deficit projected for the coming fiscal year and what that meant for borrowing requirements. But you know, we do have to remember that they have included in that some of the spending related to rebuilding from the floods, but not necessarily the revenue, come in from the federal government to pay for at least part of that. So I think that’s why, you know, we’re seeing quite a big deficit projection, quite a big borrowing in projection for B.C., certainly relative to what we saw for Alberta. I’m not sure that their deficit or their borrowing is going to be that big once we start to move through the next fiscal year. But you can talk about, has that kind of, you know, those budgets or anything else impacted spreads between the provinces and you know, what are you seeing in terms of where the value is at the moment?

Ian Pollick: Oh, for sure. I mean, I think if you know, the budget’s had a very big catalyst for some of this interprovincial basis moves and you’re absolutely right. I think, you know, it’s not too heroic an observation to say that Alberta spreads have generally outperformed everyone else, particularly Ontario as well as B.C. and that’s just a function of people very concerned that there’s not going to be a lot of supply and rightly so given where the oil price assumptions are. You know, and I think I agree with you on B.C., I think at first blush, people are a bit disappointed by the budget, but not disappointed enough that spreads moved on the back of it alone. I think it was more the general risk off tone related to the European conflict. But I think I would say is that these big capital expenditures may be accounted for, but they take a lot of time to actually be delivered. So I’d be erring on the side of less rather than more issuance as a result of that, just because we’ve seen that these big capital projects do take quite a lot of time. But listen, we have had a great show today. Thank you very much for coming on. I know you have like seven or nine kids right now, so I’ll let you go. But to everyone, we hope you have a great weekend. And remember there are no bonds harmed in the making of this podcast.

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