David Dodge on the cost of cheap money

The way forward for Canada as economic signals flash yellow

Ten years ago the global economy was in the midst of what we now call the great financial crisis. Starting in 2008 and for the following eight years central banks and governments reached into their economic policy medicine chests for bottles labelled “economic stimulus.” They administered this medicine—especially the one called “easy credit”—in prodigious quantities until finally, in late 2016, the world economy started to show signs of sustained growth. During 2017, as the global economy grew more robustly, central banks—in particular the Federal Reserve in the United States—began to reduce the dose of “easy credit” by starting to raise their policy interest rates and slowing or stopping their purchases of bonds. And they have indicated they will further reduce, though slowly, the doses of “easy credit” medicine they administer in 2018 and 2019. As a result international financial authorities have warned that the global economy could suffer withdrawal pains in the form of another great recession or a new financial crisis.

Why is it that the International Monetary Fund (IMF), the Bank for International Settlements (BIS), and other respected institutions have expressed worries about possibly severe financial turbulence when central banks raise interest rates? In response to rising inflation, are central banks even likely to raise interest rates quickly? And how is it that we might face crisis conditions again? Didn’t governments and central banks learn anything from the 2008 experience? Are the warning lights really flashing red today so that we, as Canadian citizens, should be preparing for severe financial and economic turblence ahead? Let’s see.

The massive doses of fiscal and monetary stimulus policy-makers began to apply in 2008 were intended to bolster demand and head off a 1930s-style depression. Governments including Ottawa and the provinces undertook massive spending programs, administering huge doses of deficit spending in 2009 and 2010. At the same time, central banks, including the Bank of Canada, cut interest rates effectively to zero in order to induce households to spend. These doses of stimulus medicine worked.  A global depression was averted, and by mid-2010 the global economy—Canada included—had largely stabilized.

But both the “fiscal stimulus” and the “easy credit” medicine bottles came with warning labels: “Prolonged use will lead to a build-up of debt, which will greatly increase the risk of financial and economic turbulence.” In other words, the massive government and household spending of borrowed money necessary to pull the economy out of the 2008 recession implied higher and higher debt service payments. And eventually, once some governments or households were unable to service their debt, financial and economic disruption would ensue.

Political leaders in Canada, the U.S., the U.K., and Germany took seriously the warning on the “fiscal stimulus” pill bottle. From 2012 to 2016 they reduced their fiscal deficits, and in Canada’s case budgetary balance was achieved by 2015. The consequence of this tightly managed fiscal policy was to reduce aggregate demand and thus contribute to a slower economic recovery. From 2011 to 2016 growth remained below potential. Unemployment, while declining, remained well above pre-crisis levels, and inflation remained well below the two-percent target.

Since governments—especially the Harper government in Canada—were overly zealous in reducing fiscal stimulus, central banks found themselves needing to provide some support for growth. Hence they kept interest rates at emergency levels, near or even below zero. Even though financial supervisors—including Canada’s Office of the Superintendent of Financial Institutions (OSFI)—tightened the regulations governing commercial bank lending, ultra-low policy rates combined with ongoing central bank purchases of longer-term bonds meant that credit remained both accessible and very cheap. This continuation of large doses of cheap credit helped to maintain household demand for goods and services, especially housing, thus working against the contractionary effects of both tighter fiscal policy and continued efforts of households to reduce leverage. And as long as inflation continued well below their target level of two percent, central banks were reluctant to return quickly to more normal levels of interest rates.

Low interest rates on medium- and long-term debt also had the effect of encouraging these economic actors to borrow increasing amounts relative to their incomes in order to purchase houses, other real assets, and stocks. Investors have borrowed to bid up share prices so that the ratio of share prices to corporate earnings reached an all-time high in January 2018. Households have borrowed increasing amounts, particularly to purchase houses. In the United States, where households were wildly overextended after the financial crisis, this demand for housing had the effect of stabilizing house prices at a new lower level while at the same time allowing debt-to-income levels to fall. But in Canada, where household debt was at a more manageable level after the crisis, the additional borrowing made possible by rock-bottom interest rates has caused house prices to rise sharply and the average ratio of debt to income to increase, from less than 120 percent prior to 2008, to 170 percent at the end of 2017.

By 2017, the years of monetary stimulus delivered through record low interest rates began to pay off. Growth improved in North America, Europe, and Japan, unemployment in Canada and the U.S. declined to levels last seen prior to 2008, and the outlook continues to be for even stronger growth in global output and employment in 2018. Despite the renewed strength of the Canadian and American economies in 2017, inflation did not accelerate. Core inflation remained well below the Federal Reserve’s and Bank of Canada’s common target of two percent. As a result, both central banks continued to provide a lot of monetary stimulus. They raised their policy interest rates only very modestly. By doing so, they encouraged further household borrowing, with the result that housing prices continued to rise, and households became more indebted. At the same time investors, faced with the prospect of continued minimal returns on bonds, jumped into shares. By the end of 2017, share prices relative to corporate earnings in the U.S. had reached the same levels they recorded just prior to the 1929 crash or the bursting of the dotcom bubble in 2000. Canadian markets also rose.

It is crucial to note that this historically high ratio of household debt to household income and the record high share price relative to corporate earnings could only continue without the risk of a crash if interest rates are expected to remain close to current low levels well into the future. But central banks would maintain these low policy rates if and only if they expected inflation to remain below their two-percent target in the future. And they would expect low inflation to continue only if they expected that growth would be slow enough not to create excess domestic demand. However, most analysts including those at central banks and the IMF believe that demand will be strong in 2018, continuing in 2019. As demand exceeds potential growth, they expect inflation to rise. How fast inflation will rise, and hence how far and how fast central banks should and will raise interest rates, is an open question. But the direction of rates is clearly upward in 2018 and 2019.

Simply put, the experts at the BIS and the IMF expect that this strong demand will lead to higher inflation and they expect central banks—in particular the U.S. Federal Reserve—will raise policy interest rates. These rate increases are likely to cause some financial distress for heavily indebted households and firms. Households will have to reduce consumption to meet higher debt service payments, and some investors will be forced to sell stocks. The BIS experts argue that Canadian households, among the most heavily indebted in the world today, are in a similar debt position as were American households in 2006 and 2007, prior to the financial crisis.

There is cause for concern. We now know that the BIS experts in 2006 and 2007 were correct to issue flashing red warnings about the possibility of financial turbulence arising from excessive household indebtedness; so it would be prudent to pay some attention today to their warnings about the potential consequences of high household debt as central banks raise interest rates.

While much has been done globally to strengthen the supervision of commercial banks reducing their direct and indirect exposure to mortgages, in some countries including Canada, mortgage lending has nevertheless continued apace. The BIS analysis shows that Canada is among a very small group of countries where the ratio of household debt to GDP not only exceeds 100 percent today but also has been rising steeply since the 2008 crisis. Canadian household debt has increased from 79 percent of GDP in 2007 to an estimated 101 percent in 2017. Moreover, almost half of this debt is owed by households in the bottom 60 percent of the income distribution. Households in Canada today, even with current low interest rates, devote a higher fraction of their income to interest payments than they did before the financial crisis. If over the next two years the Bank of Canada were to increase its policy interest rate back to 2007 levels, the BIS calculates that Canadian household debt service would balloon by an additional three percent of income.

This sharp increase in the fraction of income needed to service past debt would slow consumer demand, triggering a reduction in future growth of GDP and possibly a recession. In its December 2017 quarterly report, the BIS argues that an interest hike “in an economy [such as Canada’s] with high levels of household debt…would be more contractionary than an equally sized rate cut would be expansionary,” and that Canada could expect large contractions following relatively small hikes. This of course complicates the process of interest rate normalization, a complication fully appreciated by the Bank of Canada. As it said in its most recent Monetary Policy Report, “elevated levels of household debt are likely to amplify the impact of higher interest rates on consumption since increased debt-service costs are more likely to constrain some borrowers, forcing them to moderate their expenditures.”

For this reason both the Bank of Canada and the U.S. Federal Reserve have indicated that they will be cautious in raising interest rates. Until there is clear evidence that excess demand is actually triggering inflation well above their two-percent target for inflation, both central banks have indicated they will maintain monetary accommodation and keep their policy rates below the estimated “neutral” level of two-and-a-half to three-and-a-half percent.

But will rising inflation allow them to keep rates low? Economists are surprised that the tightening of labour and product markets in 2017 has not yet led to inflationary wage and price increases, but suspect that inflation could re-emerge in 2018 and 2019 as the global expansion continues. In its recent economic update, the IMF expects strong global growth to continue “as the pickup in economic activity and easier financial conditions reinforce each other.” But the IMF highlights the downside risk:

Rich asset valuations and very compressed term premiums raise the possibility of a financial market correction, which could dampen growth and confidence…A possible trigger is a faster-than-expected increase in advanced economy core inflation and interest rates as demand accelerates. If global sentiment remains strong and inflation and interest muted, then financial conditions could remain loose into the medium term, leading to a buildup of financial vulnerabilities in advanced and emerging market economies alike.

What the IMF and BIS are saying in effect is that central banks, over time, need to wean their economies off the addiction to cheap credit while at the same time continuing to administer sufficient doses of credit to avoid sharp economic contractions. If central banks can figure out the right dosages, all will be well and the Cassandras preaching financial and economic doom will be proven wrong.

Is there actually a “right” dosage as we move through 2018 and 2019, and if so, what might it be? While there are no guarantees, I think that the answer lies in a combination of three policy responses. First, there needs to be appropriate regulatory restrictions on credit creation by banks and financial institutions. Second, steady increases in policy interest rates are required to raise them to about three percent by 2019, i.e., to a rate that would be consistent with achieving two-percent inflation over the medium-term. Third, fiscal policy needs to be neutral to only mildly expansionary.

With respect to the first two considerations, the BIS suggests that “there could be a complementarity between current macroprudential regulatory measures [such as loan-to-value restrictions] seeking to dampen growth of household credit growth and future expansionary monetary policy.” In other words, the tighter lending standards now imposed by OSFI on Canadian banks may enable the Bank of Canada to provide continued monetary accommodation and to raise interest rates more slowly without triggering the risk of either excessive further credit expansion or a sharp economic contraction. With respect to fiscal policy, combined federal and provincial net borrowing (deficits) would need to be contained in 2018 and 2019 at a level no greater than that of 2017.

In fact, Canada appears to be on track to deliver appropriately small doses of both easy credit and fiscal stimulus over the next two years. The OSFI and both federal and provincial governments have taken steps and appear prepared to take more action to restrict bank lending to households. The Bank of Canada has started to raise slowly its policy interest rate, although it has not as yet provided sufficient clarity about how quickly it will move in the future. And, as long as federal and provincial governments stick to current budgetary plans for the next two years, they are likely to provide the appropriately small and very limited dose of “fiscal stimulus” to offset the Bank of Canada’s reduced dosage of “easy credit.” While Canada may face economic turbulence due to geopolitical developments, as well as perverse economic policies of our trading partners, our fiscal and monetary policies are basically on track to steer us through the narrow passage between recession and inflation and between financial boom and bust.

But it is difficult to be as sanguine about U.S. policy. The recent U.S. tax bill will deliver massive amounts of fiscal stimulus in 2018 and 2019 and proposed financial sector deregulation will ease credit conditions. Domestic American demand will thus be very strong, and wage and price inflation will, in all likelihood, increase significantly. Under these conditions, the Federal Reserve under its new chair will have to increase interest rates. The longer it delays in doing so, the greater the increase will likely have to be, and the greater the chance of a sharp economic and financial correction in the United States. For the U.S., the BIS, and the IMF, concerns about a future financial and economic crisis are indeed more pertinent because of the stronger likelihood that the Americans will not deliver appropriate combined dosages of policy medicines over the next two or three years.

Thus the IMF’s and the BIS’s worries that possible economic and financial turbulence lie ahead as inflation increases in response to strong economic growth have a legitimate foundation. Once inflation nears or threatens to exceed two-percent target levels, central banks will raise their policy interest rates. Because households have accumulated very high levels of debt during the last decade of cheap credit, this trend is likely to force households to cut current spending significantly in order to be able to pay the rising costs on debt they have already accumulated. And this reduction in consumption, and associated reduction in demand for housing, is likely to cause a reduction in aggregate demand and a sharp slowdown in the growth of employment and incomes.

Undoubtedly the risk of such a contraction exists in 2019 and perhaps even more so in 2020.  But, despite the very high ratio of debt to income in Canada, I think the risk of financial turbulence and a future economic contraction due to rising inflation and interest rates in 2018 and 2019 is relatively low.  On the other hand, even though American household debt relative to income is less stretched than in Canada, the BIS warnings of possible financial turbulence may have somewhat more salience in that country. Because U.S. authorities are set to ease regulatory restrictions on financial institutions, and because the federal government will deliver a very large dose of stimulus medicine through the recent tax cut, the current IMF forecast of U.S. growth of very close to three percent in each of 2018 and 2019 may actually be achieved and inflation may increase significantly. For the U.S., the lights warning of serious financial and economic turbulence ahead—turbulence far greater than a 10- or 15-percent stock market correction—are flashing yellow.