While the Federal Reserve - rightly or wrongly - has initiated a rate hiking cycle, it is not a given that the central bank in neighboring Canada should follow suit. In fact, according to our composited indicator for Canada monetary conditions, monetary policy is too tight for the Bank of Canada to hit its 2% inflation target over the medium term.
The Bank of Canada will announce its rate decision on Wednesday, and we should stress that our indicator does not say what the BoC will do, but rather what it ought to do to ensure it will hit its 2% inflation target over the medium term (2-3 years).
Four key monetary indicators
In February, we - Markets & Money Advisory - will start to publish our Global Monetary Conditions Indicator covering monetary conditions in around 30 countries around the globe. Canada is one of those countries.
In the Monitor, we will publish a composite indicator for monetary conditions in each of these 30 countries, and the indicator will be based on four sub-indicators - broad money supply growth (typically M2 or M3), nominal GDP growth, exchange rate developments and the level of the key policy rate.
For these four sub-indicators, we define what we call a policy-consistent growth rate, which means that this would be the needed growth rate of, for example, M2 or nominal GDP to ensure that a given central bank hits its inflation target over the medium term, given the development in factors outside of the direct control of the central bank - for example, money velocity trend, real GDP or foreign price developments.
The composite indicator is then a weighted average of these four sub-indicators, and the indicator is calibrated so that a zero score in the indicator indicates that it is likely that inflation will be in line with the inflation target (in the case of Canada 2%) within the next 2-3 years.
Below you see the four sub-indicators for Canadian monetary conditions.
Overall, we see that while broad money supply growth (M3) is broadly in line with the policy-consistent growth path, the three other indicators have been on the "tight side" for the past 1-2 years.
At the root of this excessive tightening of monetary conditions likely is the fact that the drop in global oil prices, which started in 2014 caused the Bank of Canada to essentially hit the Zero Lower Bound on interest rates, and as the BoC (so far) has refused to implement monetary easing through the use of other instruments - for example intervention in the FX market - monetary conditions have more or less "automatically" become too tight since early 2015.
This is very similar to the development in other countries with otherwise successful monetary policy - Norway and Australia - where monetary conditions also have been tightening excessively over the past 1-2 years.
BoC likely to undershoot its inflation target in the medium term
The graph below shows our composite indicator for Canadian monetary conditions.
We see that the indicator has been trending downwards since early 2014 - indicating a tightening of monetary conditions, and since early 2015, the indicator has been below zero, indicating downward risks relative to BoC's inflation target and recently the indicator has dropped below -0.5.
We overall define the range from -0.5 to +0.5 to be 'broadly neutral' monetary conditions. Hence, presently monetary conditions are excessively tight.
Concluding, it might be that the Federal Reserve will hike interest rates further in 2017, but the Bank of Canada certainly should not be in a hurry to hike rates given the fact that monetary conditions presently are too tight to ensure that the BoC will hit its inflation target in the medium term.
In fact, the most important issue for the BoC seems to much more clearly articulate how it plans to conduct monetary policy at the Zero Lower Bound. A possibility would be to use the exchange rate as an intermediate target/instrument to implement an easing of monetary condition at the Zero Lower Bound. See more on this here and here.
However, one thing is what the BoC will do and we should stress that the purpose of our Global Monetary Conditions Monitor is not to forecast monetary policy action, but rather to evaluate in a consistent and objective way the monetary stance of a given country such as Canada.