1. Global Economic & Financial Outlook: Implications for the Bond Market Wednesday, 8 November, 2017
Presented by
David A. Dodge
C.B.I.A Conference

2. Recent Economic Developments
The Global Economy has strengthened since last fall.
Much of the considerable slack that existed in advanced economies in early 2016 has been absorbed.
China continues to grow strongly.
Emerging market economies have strengthened.
Global Growth now at notional speed limit of 3½%.

3. Recent Policy Developments
Central Banks are beginning to raise policy rates slowly but monetary conditions are set to remain accommodative over most of the next two years.
Financial Regulation likely less restrictive in U.S.
Now expect only modest U.S. fiscal stimulation to growth, but European fiscal policies less “austere” and mildly stimulative.
Chinese fiscal and monetary policy remains expansionary.
U.S. trade policy unsettling.

4. Outlook Short-term Prospects for Output Growth (%) Share (%) 2017 2018
2019
Canada
1.5
3.1 (2.4)
2.1
1.6
United States
16.4
2.2 (2.3)
2.3
2.0
Euro area
12.3
2.1 (1.5)
1.8
Japan
4.6
1.5 (0.6)
0.8
0.7
Advanced economies1
34.8
2.1 (1.8)
1.9
China 17
6.7 (5.7)
6.5
6.3
Rest of World
48.2
3.3 (3.2)
3.6
World
100
3.5 (3.1)
3.5
3.4
Weighted average of Canada, United States, Euro area and Japan. Figures in brackets from Fall 2016 Outlook.

5. Key Financial Market Uncertainties
What is the current real “natural rate” of interest?
What is the current “neutral policy rate” for central banks?
What do central banks mean by “policies will be data dependent”?

6. “Natural Rate” of Interest
“Natural rate” equates real supply and demand for saving (S=I).
Over very long run estimated at 2% in real terms.
But recently, natural rate has been falling for structural reasons.
Now estimated to be one percent or less.
Implications for long bonds and Central Bank balance sheets.

8. “Neutral” Policy Rate for Central Banks (r*)
While natural rate balances long term real demand and supply of savings, in the short run central banks determine nominal rates.
The “neutral rate” is that which monetary policy is estimated to be providing neither expansionary nor restrictive impact on growth in the real economy, when the economy is in balance and expected inflation is at target of 2%.
It depends on market structure and expectations.
It is unobservable but currently judged to be about 3% in the U.S. and Canada.

9. Monetary Policy in Principle
Underlying policy objective is to keep aggregate supply and demand in balance with inflation centered on 2%.
When aggregate excess demand is evident policy rate should be restrictive, above 3% more or less.
When excess supply is evident policy rate should be accommodative, below more or less 3%.
Central banks use various inflation and employment indicators to judge current and future state of excess demand.

10. Policy Conundrum
Unemployment is low and falling indicating strong demand. In Canada and even more so in the U.S., it is below estimated NAIRU.
But prices and wages in North America are not yet accelerating.

12. Year-Over-Year Growth in Wages and Prices (%)
2014
2015
2016
2017
U.S.
Wages (AHE)
2.1
2.2
2.5
2.9 (Sept)
Prices (CPI)
1.6
0.1
1.3
2.2 (Sept)
Prices (CPI core)
1.7
1.8
1.7 (Sept)
Canadian
2.4
1.2
0.6 (Aug)
2.0
1.1
1.4
1.6 (Sept)
1.2 (Sept)
CPI core: CPI all items excluding food and energy (and indirect tax effects in Canada)
AHE: Average hourly earnings – all employees (private sector in the U.S.)

13. Possible Reasons for Conundrum (1)
Temporary Factors:
Commodity price movements
Exchange rate movements
Idiosyncratic variations
CPI measurement problems

14. Possible Reasons for Conundrum (2)
Structural change in labour market
Lower than estimated natural rate of unemployment holds down labour costs
Structural change in product markets
More competition domestically
More foreign competition
Structural change in production technology
Unmeasured productivity gains get bigger

15. Implications of Structural Change
Economy can run “hotter” without inflation (NAIRU is lower).
Monetary policy could be accommodative for longer.
Fiscal policy could be more expansionary today.

16. How to Deal with Conundrum (1)
“Radical Uncertainty”.
Possibly conundrum will self-resolve and inflation will rise as historical models predict, but analysts uncertain.
Until clear evidence of rising inflation, one view is to keep policy interest rate below “neutral”. This is what some central bankers mean when they say that policy is data dependent.

17. How to Deal with Conundrum (2)
Central Banks still remember inflation experience of 1970s and 1980s.
Also reminded by BIS that abnormally low interest rates led to increased debt levels greater leverage and financial instability.

18. Implications of Uncertainty
Inflation targeting model subject to wider margin of slippage, but not broken.
Central banks uncertain but, fearing instability or future inflation, will cautiously reduce accommodation.

19. Bonds
Ultra low policy rates and expansion of Federal Reserve and ECB balance sheets (QE) have squeezed risk spreads and term premia.
Reduced risk spreads have led to corporate over leverage.
Increased default risk as central banks reduce accommodation.
Reduced monetary accommodation implies shrinkage (or at least no further expansion) of central bank balance sheets.

20. Implications for Bond Rates
The Federal Reserve has indicated that it will follow a slow, orderly shrinkage of its balance sheet.
This inevitably implies an increase in the term premium.
To maintain same total accommodation, this implies somewhat slower increase in the policy rate.
Mix (treasuries/MBS) also matters.
Yield on 10 year treasuries probably about 3% by end 2018.

21. Implication for Policy Rates
Federal Reserve most likely to raise policy rate to about 2% by end 2018.
Bank of Canada likely to raise policy rate to about 1¾% by end 2018.
ECB to begin to raise policy rate in late 2018 or 2019.

22. Prudent Planning Parameters to End 2018
Less than one percentage point increase in interest rates in Canada and U.S.
WTI oil stays below $60 U.S./bbl.
Canadian dollar around 80¢ U.S.
Ongoing NAFTA uncertainty.
Minor stimulative boost from U.S. fiscal/tax policy.
Chinese policy remains stimulative.
Canadian growth slows to 2.1% in 2018, and 1.6% in 2019.

23. Remarks by David A. Dodge
C.B.I.A Conference
Wednesday, 8 November, 2017
Toronto, Ontario