Thursday, January 22, 2015

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.


  1. I would rather think that BNM should have reduced the OPR to 3.0% and see how it goes from there. But I get the feeling that BNM is being tentative on three fronts a) its desire to keep a tight leash on inflation b) it is leery of igniting higher Household Debt etc c)further depreciation in the MYR.

    But I would still go for it to sustain local AD given the iffy external headwinds.

    On another note, I think there is an overreaction verging on panic regarding the local economy. I mean people will always have views regarding economic dynamics based unfortunately an over-reliance on experts and a vague understanding of fundamentals. But to come up comments like these:

    "The report also noted that foreign investors own 44% of Malaysian bonds. What would happen if "they run for the exit"?"

    is verging on the absurd. I just came from somewhere which implies nothing of the sort:

    But then again, two years ago, India was touted to be the emerging basket case and now this:

    so what's next? China to end up on skid row for posting 7% GDP?!!

    Warrior 231

    1. @Warrior

      I agree. The pessimism is crazy. We're talking about maybe 0.5%-1.0% less growth. People are talking as if we're falling into recession.

  2. Warrior, I think this people, especially local are intellectual bankrupt. They do not want to take 1 minute to active their brain cell but just repeat what the rating agencies said and it is the end of the road for Malaysia as it is.

    What a lot of crap. The 10 year MSG yield has drop back to almost normal and the FED is just "thinking" only, and everyone goes ga ga, for what, a possible 0.5% (wow so high) increase in the base rate.

    Just wait for the show that is starting now between Congress and Obama, one will think that Congress leader is now the President of USA.

    I think this time US will default.

    Zuo De

  3. Zuo De

    The danger is that such negativity becomes a self-fulfilling prophecy. Most if not all, economic conflagrations, start from the loss of a subjective abstraction, 'confidence', which is usually precipitated by loose talk and uninformed conjectures. Reason goes missing in the debate and panic sets in as the herd mentality gathers steam and soon you have everyone bar the cat beating for the exits.

    Very few economists have accurately predicted a crisis cos it is a very fluid and dynamic spectre, lurking unnoticed and bursting into sudden life. Even Roubini who foretold the 2008 GFC admitted that he was taken aback by its breadth and depth. Economics is a tricky pseudoscience trying its darnest to act all empirical, objective and scientific while still relying on speculation and conjecture plus a whole laod of iffy assumptions. Thankfully, most economists I know acknowledge its pseudo-science inclinations to avoid being aughed at. After all, the whole process of divining trends, crisis etc dependent on a crucial variable; human behavior which is imposssible to fathom or predict anyway.

    That's why fancy modeling is no substitute for real-time action. There will be those (economists included) who will disagree vehemently but the fact that economic history is littered with tales of booms and busts, by default implies, its expert diviners do not possess adequate tools to account for everything economic. Its more a work in progress, constantly thwarted by shifting economic paradigms. Throw into that political contortions and you have a harder job in front of you. And I doubt it will have the requisite tools in the immediate future given past theories and classical models have been dissed in contemporary times as maverick approaches have gained credence. So economics is mired in quicksand with no firm foothold to latch onto and consequently is in constant need to refine or review its approaches.

    That is why econmic analysis should always be taken with a pinch of salt for doomsaying sells just like sensationalism or shock jocking. Ultimately, if the US feels enough creative destruction has been wrought on its shale O&G production capacity and starts arm twisting the Saudis to cap production, oil prices will zoom upwards in a jiffy and all these empty chatter will cease and be forgotten by the very chattering classes who spewed the nonsense in the first place. Or if the ECB launches their version of QE or China kcks back into life....see the permutations are endless.....

    Yes, there is cause for concern but it must be tempered by a rational understanding of fundamentals and any action undertaken must be guided by hard facts not blase intuition. This is in no way, a defense of any economic policy which by the way, I have been critical of in this and other fora.But I am not about to kick someone in the head just because he/she is lying prone on the dint of past policy failure and neither do I intend to ventilate my personal/political angst with an axe grinder in hand. The best thing to do as my Prophet (pbuh & hf) would say is to shut up if one has nothing better or positive to say.

    Warrior 231

  4. Zuo De

    Here are three latest wire reports that should stir fresh questions.

    1. Will the US increase rates if this trend in joblessness persists:

    If so, what happens to EMEs?

    2. What happens now to investors in the Euro in search of yields as ECB commences QE and interest rates there plummet:

    Whither then but the EMEs for the Euro carry trade?

    3. What will be the impact of this maverick move by the Swiss and the Danes if imitated elsewhere:

    A month or so back, I wrote here in passing about the specter of deflation. Well, it is slowly becoming an increasingly likely outcome.

    So what next, if it really materializes.

    World War 3 or World War Z? We already have the embers smouldering in Islam vs Christiandom ala Huntington's thesis.....the actors are getting ready, cue Iran, Israel, IS, the US and allies, Russia, North Korea and definitely China and what better way to jump-start the global economy then via Armageddon. Hope the sophisticated analysts hanging round here as knowledgeable wonks would give us their tuppence.

    See what can happen in a split second in an interconnected 24/7/365 global marketplace. No wonder, economists cant keep pace...hahaha

    Warrior 231