While on the one hand the Monetary Policy Report (MPR) presents an economy evolving pretty much as expected, it also underscores the key risks to the macro outlook and the uncertainty about their evolution.
One area of uncertainty is the Bank’s expectation of higher potential output growth based on an expectation of higher labour productivity growth, spurred by a positive trend in investment spending. Investment spending disappointed last year, but the Bank expects it to “reassert itself” in Q2, and points to strong machinery imports in the last quarter of 2017. As for labour input growth, the Bank estimates it will remain the same as in the January MPR, but sees potential for more jobs coming online. The Bank points to a youth participation rate that “has room to increase,” as well as to labour market slack in the Oil Patch, and notes that wage growth remains below the three-per-cent pace consistent with zero labour slack.
Yet the notion of potential is a fuzzy one. After all, it cannot be observed directly from the data – it has to be inferred. And as the Bank admits, a lot of variables that are difficult to forecast have to align to get it just right. Despite these risks, the Bank is still firmly on a path to removing accommodation, and the new MPR reinforces its data dependency in getting to the terminal overnight rate estimate of 2.5 percent to 3.5 percent. Over time, it is expecting the economy’s growth profile to shift, as household spending’s contribution declines and that of business investment and exports increases.
It’s a tidy story, but market seems to be questioning the Bank’s picture of things going along according to plan, more or less. The biggest sign of this dissonance is the yield curve bending flat, which has historically been suggestive of a slowdown in the real world. Market-watchers are largely ignoring it, however, because the perception is that the macro environment is so substantially different, where unconventional monetary policy is still in effect even as policymakers are concurrently unwinding it. That leads to dislocations in interpreting the traditional signals.
For now, we are interpreting the Q1 data as a soft patch for growth (it has happened before), and not as the beginning of an extended downturn. Our models still point to above-trend global synchronized growth. We continue to hew to the Bank’s outlook; we do not expect it will turn around and cut rates.
Nevertheless, investors should consider some response to the risks. In our active portfolios, we are maintaining an underweight stance relative to the spread, taking on some duration risk. In this new macroeconomic environment, the signs flashing slowdown in the near term might well turn out to be false alarms. But investors should think twice about ignoring them.