A Lesson In Macro Policy Choices

The Bank of Canada yesterday surprised everyone by cutting its policy rate by 25bps (excerpt):

Bank of Canada lowers overnight rate target to 3/4 per cent

The Bank of Canada today announced that it is lowering its target for the overnight rate by one-quarter of one percentage point to 3/4 per cent. The Bank Rate is correspondingly 1 per cent and the deposit rate is 1/2 per cent. This decision is in response to the recent sharp drop in oil prices, which will be negative for growth and underlying inflation in Canada….

…Oil’s sharp decline in the past six months is expected to boost global economic growth, especially in the United States, while widening the divergences among economies. Persistent headwinds from deleveraging and lingering uncertainty will influence the extent to which some oil-importing countries benefit from lower prices. The Bank’s base-case projection assumes oil prices around US$60 per barrel. Prices are currently lower but our belief is that prices over the medium term are likely to be higher.

The oil price shock is occurring against a backdrop of solid and more broadly-based growth in Canada in recent quarters. Outside the energy sector, we are beginning to see the anticipated sequence of increased foreign demand, stronger exports, improved business confidence and investment, and employment growth. However, there is considerable uncertainty about the speed with which this sequence will evolve and how it will be affected by the drop in oil prices. Business investment in the energy-producing sector will decline. Canada’s weaker terms of trade will have an adverse impact on incomes and wealth, reducing domestic demand growth.

That’s the second big policy surprise in the past two weeks (the Swiss National Bank move to abandon the Euro peg was the other). We’re seeing considerable divergence in monetary policy settings, more or less as predicted, but the players have not been the ones people have been expecting. Brazil for instance yesterday raised their policy rate, while Peru cut theirs instead last week. The ECB announcement later tonight will, I suspect, be a damp squib by comparison.

What I want to explore in this post is the different reactions of policy makers to the drop in oil prices. Both Canada and Malaysia are major oil and gas producers, with Canada standing at number 5 overall in the world, while Malaysia is the global number 2 in LNG. The sharp drop in oil prices would have slightly different effects on each country because of the different product mixes, but should be otherwise similar enough that I’m going to gloss that over. The immediate economic effect would be the same – a decline in the terms of trade (you get less for your exports relative to your imports), and a decline in domestic income and wealth.

I’ll add in Australia, which has been similarly affected, though more from the just-as-severe drop in iron ore prices than from oil & gas.

Yet the policy responses have been quite different. While Canada has loosened monetary policy, Malaysia has slightly loosened fiscal policy (I'd actually call it pretty neutral, due to the negative multiplier impact of lower spending). Australia in the meantime has kept monetary policy on hold, but also opted to keep fiscal expenditure constant despite a projected drop in revenue i.e. they let the deficit automatically increase, thereby also loosening fiscal policy, though to a much greater degree than Malaysia has.

Why the difference? All three countries are commodity exporters facing similar economic headwinds. One would think the policy response would be similar – in fact that would be the layman’s instinct (although I’ve already read one regional research house speculating on a BNM rate cut this year because of the BoC action). Yet Australia and Canada have reacted by loosening macro policy, but Malaysia has cut government expenditure instead.

The trick is to look at what economists like to call “initial conditions”. If the characteristics of the situation were the same, so would the response. But if you start off on a different foot, the response would be different.

So here’s a thumbnail sketch of all three countries (all data from the IMF’s Oct 14 World Economic Outlook, and yes, I know they’re different from the latest official figures):

	GDP growth (2014f)	Gross Debt to GDP	Fiscal Balance to GDP	Current Account to GDP	Unemployment rate	Policy rate	Inflation
Australia	2.80%	30.60%	-3.30%	-3.60%	6.20%	2.50%	2.70%
Canada	2.30%	88.10%	-2.60%	-2.60%	7.00%	1.00%	1.90%
Malaysia	5.90%	56.60%	-3.60%	4.30%	3.00%	3.25%	2.90%

Here we see the different situations policymakers face in each country. Apart from being commodity producers, most of the main variables are quite different:

1. Australia has a low debt to GDP ratio, runs twin deficits, a highish unemployment rate and higher than average inflation;
2. Canada has a high debt to GDP ratio, but also runs twin deficits, a highish unemployment rate and middling inflation (in fact spot on with the BOC’s target);
3. Malaysia has a middling debt to GDP ratio, but has a fiscal deficit paired with a current account surplus, a low unemployment rate and above average inflation.

I think the key to looking at the different policy responses here is the debt to GDP ratio. Canada’s higher debt burden means a bias towards tighter fiscal policy and looser monetary policy. Australia is just the opposite: a low debt to GDP ratio allows a more relaxed approach towards expanding fiscal policy, allowing monetary policy to focus on inflation.

Malaysia, being in between, adopted the middle of the road approach of effectively not doing much of anything at all, though the numbers do indicate room to cut the OPR if necessary. All three countries, by the way, have suffered sharp currency depreciation though the AUD has been the worst hit of the lot. That’s a de facto loosening of monetary policy, over and above any changes in policy rates.

For Malaysia, given the government’s desire to balance the budget by 2020, the burden of adjusting to macro shocks falls almost fully on BNM. However, the Governor appears to think that the OPR at 3.25% is still accommodative enough. Given the expectations that the current account surplus will drop to 1%-2% in 2015, that may be the right call.