Poloz Trumped by tariff threats

It seems quite likely that the audience that pitched up to the Greater Victoria Chamber of Commerce this Wednesday to hear Bank of Canada Governor Stephen Poloz were taken aback by his formal remarks.  Instead of the usual tour d'horizon of the economic situation, Poloz spoke about how he and his colleagues at the Bank are trying to increase transparency, for the benefit of financial market participants and the public at large. Poloz wants the Bank's activities to be understood by people without an economics degree.  This puts him in a very different camp from many other central bankers:  Alan Greenspan, for example, actually seemed to be offended when his audiences picked up on his meaning too easily.

Towards the end of the speech, Governor Poloz made some general comments about the particular difficulties the Bank is facing in setting policy in the current environment, and it is these comments that have received the most attention from the media.  After explaining why the Bank no longer offers as much "forward guidance" as it used to, he stated that

There is always a degree of uncertainty when using economic models, but these days there is a litany of things we simply do not know. These include the degree to which uncertainty about trade policy is holding back business investment, how new guidelines for mortgage lending are affecting the housing market, and how sensitive the economy is to higher interest rates given the accumulation of household debt.

And then

This is why we say that the Bank is particularly data-dependent right now. 

Given signs of weakness in the recent data flow,  these comments have caused market participants to scale back their expectations for a rate hike in July.  The latest monthly data showed that the gradual upward trend in CPI has stalled, while retail sales unexpectedly declined,  April GDP data, due for release this Friday, are expected to be weak.

Overshadowing everything is the threat of an escalating tariff war with the United States.  Canada's retaliatory tariffs against Trump's steel and aluminum levies are set to kick in on July 1, and it would be entirely in keeping with Trump's character if he responded with a fresh set of tariffs of his own.  He has already threatened tariffs on imported cars, and economists are starting to quantify what the impact of such a move might be.  One study suggests 165,000 Canadian jobs could be put at risk, the vast majority of them in Ontario.  Linda Hasenfratz, CEO of Linamar Machine, Canada's second-largest car parts maker, says such tariffs would be "the final step to economic disaster".

For now, markets are still seeing more than a 50 percent chance of a rate hike next month, but given the speed with which things are developing on the trade front, those odds could well change by the time the Bank announces its decision on July 11.

Canada's milk shakedown

One of Donald Trump's most frequent complaints about Canada's trade practices concerns the dairy industry.  It's one of the few cases where he has his facts straight.  Canada really does charge tariffs of almost 300 percent on a variety of dairy products, effectively keeping US farmers out of the domestic market.

The tariffs are part of Canada's system of "supply management", in which the government conspires with farmers to limit the amount of particular commodities that are produced domestically, by means of a system of quotas, while keeping virtually all imports out of the country.  It's one of the most egregious examples of "producer capture" (also called producer surplus) anywhere in the developed world, and it means that Canadians pay far more for milk, cheese and eggs than do our neighbours to the south.

The supply management system is something of a third rail in Canadian politics.  The country's dairy farmers, many of them located in Quebec, punch well above their collective weight in maintaining the system regardless of which party is in power. The leader of the federal Conservative Party recently fired one of his most senior colleagues for daring to question the need for it. Justin Trudeau has made it very clear that his government will not make any concessions on supply management in the ongoing NAFTA negotiations.

This article, from Bloomberg via The Toronto Star, provides an excellent summary of how supply management works and how it has distorted the market. Unsurprisingly, Canadian dairy farmers make much more money than farmers producing products for which there is no supply management.  It's remarkable to learn that when dairy farmers look to borrow money, the key collateral they can offer to a lender is not their land and buildings, but their production quota, which is basically a perpetual annuity.  The total value of Canadian dairy quotas is now C$ 35 billion, which suggests that ripping off the consumer is a very lucrative proposition.

There seems little likelihood that supply management will go away any time soon, and the fact that the quotas have been posted as collateral for so many loans would make unwinding the whole mess vary complicated and expensive.  Still, nothing is forever.  Casting about for a comparison to the quota system, I thought about the taxi "medallions" that used to form an important part of that business in many cities, including New York and Toronto.  Those medallions used to change hands for tens of thousands of dollars because they brought with them the right to join a seemingly impregnable cartel.  Then along came Uber and Lyft.  It's hard to see how anyone could do anything comparable in the Canadian dairy industry, given that the government is effectively part of the scam, but we live in hope. 

Canadian household debt heads lower

It's starting to look as though the multi-year rise in Canadian households' debt burden is really over.  StatsCan reported today that the debt-to-income ratio slipped in the first quarter of this year to 1.68.  That's the lowest level in two years, and compares to a peak ratio of 1.70 seen in the third quarter of last year.  Although the debt/income ratio generally falls in the first quarter of every year, the decline this year is the biggest on record.

The turnaround appears to be directly related to tightened mortgage lending rules, rather than any sudden epiphany on the part of borrowers.  This is confirmed by the fact that new mortgage lending in the first quarter was the lowest since the second quarter of 2014.  There is plenty of anecdotal evidence that borrowers unable to secure financing from banks under the new rules are turning to more expensive non-bank lenders -- witness the ever-present ads for "Harold the mortgage closer" on local TV stations*.  Of course, by its very nature such borrowing is much harder for StatsCan to keep track of.

Today's data support last week's assertion from the Bank of Canada that the systemic risk posed by excessive debt is starting to ease.  Even so, the debt/income ratio remains well above the levels that prompted the financial crisis in the US a decade ago.  As long as incomes continue to rise, the debt burden will continue to edge lower, but if anything causes the employment situation to turn sour -- a trade war with the US, for example -- the risks to the financial system and the overall economy will start to increase again.

* Until quite recently the lugubrious Harold was mainly in the business of pawning gold and jewelry. 

Leaning into Trump

The Federal Reserve raised the funds target by 25 basis points to 2 percent today, in line with the universal expectation of market watchers. The FOMC statement  noted strength in consumption and business investment, the continuing decline in unemployment and the gentle upward pressure on core measures of inflation as factors supporting its decision to continue the gradual removal of monetary stimulus.  Two further 25 bp rate hikes are likely by year end.

The Fed is doing exactly what is expected of it in circumstances of full capacity utilization. It isn't taking away the punchbowl just as the party starts to get interesting, but it is trying to ensure that when the party does eventually end, nobody wakes up with too big a hangover.  Contrast that with the behaviour of the Trump administration, which seems to be going out of its way to make the economy overheat. 

The fiscal stimulus provided by this year's budget is exactly what the economy doesn't need when the unemployment rate is as low as it is, at 3.8 percent: additional inflation pressures are the only possible result. Of course, Trump and his economic team profess to believe that the official unemployment rate is way off base, quoting a variety of studies that suggest the actual rate is very much higher. (Here is a relatively moderate example).  Even if this is true to some degree, it is unlikely that the "missing" unemployed will match up well with the job opportunities that may result from the added fiscal stimulus.

Then there are the President's tariff measures, which are certain to add to domestic cost pressures.  Either US companies will choose to pay the tariffs, or because they will opt to switch to domestic suppliers, which will inevitably be more expensive, because if they weren't, the imports wouldn't be arriving in the first place.  If Trump proceeds next to impose tariffs on imported autos, the impact on the cost base and competitiveness of the US car industry would be very severe.

With Trump unlikely to change course on the fiscal front, the Fed is likely to have to keep tightening monetary policy well beyond this year.  How long will it be before Trump, who cannot brook disagreement, starts to take notice?

Doug Ford: Trump without the ideas

Winning just above 40 percent of the popular vote, Doug Ford's Conservatives won a thumping majority in yesterday's Ontario provincial election.  The left-leaning NDP, which at one point in the campaign was polling equally with the Conservatives, will be the official opposition.  Former Premier Kathleen Wynne's Liberals were massacred, electing only 7 MPPs and thus losing official status in the legislature.  And Ontario elected its first Green Party MPP.

Comparisons between Doug Ford and Donald Trump have been commonplace during the campaign, and to be sure, there are similarities.  Both are heirs to considerable wealth, posing as self-made men yet somehow still part of the aggrieved middle class.  Both have a tendency to bizarre off-the-cuff statements and general boorishness.  However, there are some important differences.  In Trump's case, you may not have liked the ideas he promoted during the election campaign -- abolish Obamacare, move the US embassy in Israel to Jerusalem, cut taxes, toughen up on Iran and so on -- but you recognized they were all things he might actually be able to do if elected, and you could vote accordingly.

By contrast, the "platform" on which Doug Ford has been elected is a motley collection of half-baked notions, many of which are either meaningless in practice or outright impossible.  A small sample:

• Ford plans to cut the cost of a gallon of gasoline by 10 cents by way of a reduction in the Provincial excise tax.  This sounds all well and good, but I clearly recall that the last two occasions I gassed up the ride, there was a difference of more than 15 cents a gallon in the two prices I paid.  Given the day-to-day volatility in retail gas prices in the Province, Ford's plan would cut Provincial revenues without making any meaningful (or even noticeable) difference at the pumps.

• Ford promises to fire the CEO of Hydro One, the principal electrical transmission utility, on the grounds he is overpaid.  Indeed he is, but since Ms Wynne has privatized more than half the company, this is not a promise that Ford can easily keep.  And if he does, said CEO walks away with an 8-figure severance deal, which is hardly likely to go down well with the voters.

• Ford promises to find $6 billion in "efficiencies" in government spending, equivalent to about 4 percent, without firing anyone from the public service.  Efficiencies are a good thing, of course: they mean you can do more with less.  But since something of the order of two-thirds of public spending goes to salaries and benefits, that "less" can only mean fewer public servants.  This is an unsquarable circle, and this promise may be the one that comes back to haunt Ford early in his mandate, when he tables his first budget.

• And speaking of the budget, Ford offered no detailed costing of his ramshackle platform during the election campaign, contenting himself with a promise to restore the budget to balance some time in his four-year term.  However, independent analyses suggest that Ford's plans will actually lead to bigger deficits than either the Liberals or NDP were set to record if they were elected.  Expect Ford to follow the time-honoured tradition of "discovering" that the fiscal cupboard has been left bare by his predecessors, as a prelude to breaking all manner of election pledges.

The list goes on, but that's a representative sample.  There may be some comfort to be found in the fact that some good people have been elected alongside Ford, including a former senior banking colleague of yours truly.  But here, alas, we circle back to the comparisons with Trump.  Neither man looks much like a team player.  The adults in the room haven't restrained Trump, and it's unlikely they will be able to stop Ford from following his instincts, for better or worse.     

Bank of Canada sees risks easing

In many respects, the Bank of Canada's Financial System Review, published today, offers more of the same.  The Bank still believes that the greatest risks to financial system stability are posed by the interlinked problems of household indebtedness and an unbalance housing market, with cyber threats not far behind.  However, the Bank now sees signs that these risks are beginning to moderate, although it will take some time for them to disappear completely.

In recent months, the vertiginous climb in household debt has slowed, in response to both rising interest rates and new regulations aimed at curbing excessive mortgage borrowing.  At the same time, the burden that the debt represents has eased somewhat as the strong economy and labour market lift household incomes. House prices have fallen, notably in the key Toronto market, but there has been no sudden collapse in the market, which could have led to widespread problems for both borrowers and lenders.  The Bank sees these developments as "encouraging", while noting that the sheer size of the accumulated debt means that the vulnerability will persist for some time to come.

As for the cyber threat, the Bank reports that it has been working with the major banks to ensure that the payments system can recover quickly in the event of a successful cyber attack.  The recent brief chaos caused across Europe by the sudden failure of the Visa payments system, together with the speed with which the system was brought back online, underlines the importance of such efforts.

What could go wrong?  The Bank identifies the same three key risks as in its last Review, published in November 2017:  a sudden collapse of overheated housing markets; a sharp increase in global long-term interest rates; and a severe Canada-wide recession.  The Bank sees little change in the probability of any of these events, which is a little surprising.  The likelihood of a sudden collapse in the housing market has surely diminished in recent months, as the Bank notes elsewhere in the Review.  In contrast, the risk of a sharp increase in long-term interest rates may have increased, in light of the fiscal irresponsibility of the Trump administration in an economy that is already dangerously close to overheating.

As for the risk of a severe Canada-wide recession, the possibility that a downturn could be triggered by US withdrawal from NAFTA or by a trade war has undoubtedly increased.  In this context there may be some reassurance to be found in the latest IMF assessment of Canada's economy, published earlier this week.   The Fund sees GDP growth slowing from 2017's 3 percent pace to just above 2 percent this year and next.  However, it notes that a collapse of NAFTA and its replacement by "WTO rules" would cut the growth rate by at least 0.4 percent.  That doesn't sound too scary, until you recall that the Trump administration has clearly signalled in the last few weeks that it has no intention of following WTO rules.  In light of that, the IMF's assessment looks very much like a best case; things could turn out very much worse.

Canada-US trade factcheck

With NAFTA talks seemingly at an impasse and an embryonic trade war under way, it often seems that Canadian and US trade officials are talking past each other.  Canada claims it runs a deficit in its dealings with the US; the US claims the exact opposite.  Who's right? In a sense, they both are.

Statistics Canada today released Canada's merchandise trade data for April.  The overall report was healthy enough, thanks to a surge in export volumes and a small decline in imports.  But let's look specifically at Canada-US trade.  What do we see?  Canada's trade surplus with its southern neighbour (and by far its biggest trading partner) rose to C$ 3.6 billion in the month.  That's almost double the surplus seen in March, but is actually lower than the surplus of $4.4 billion recorded in April 2017.  The fact is that Canada almost always runs a surplus in goods trade with the US, mainly as a result of shipments of commodities, including energy.

So Trump's right then?  Well, no.  These numbers relate only to merchandise trade. Trade in services (insurance, banking, entertainment, travel and everything else) is a different matter.  In services the US consistently runs a surplus in its trade with Canada (and, for that matter, with most other countries). Canada's deficit in services swamps the surplus it achieves in goods trade, with the result that the overall current account (goods and services), is routinely in deficit, particularly with the United States.

As I have suggested here before, it's no surprise that Trump and his team focus on the merchandise trade data, which support their narrative, rather than the more comprehensive current account data.  Trump's base of support is overwhelmingly located in what are sometimes dismissed as the "flyover states", basically everything between New York and California.

The bankers and insurance agents and entertainers on the two coasts may be racking up huge surpluses with the rest of the world, but they're not going to vote for Trump anyway.  The rest of the country -- the rust belt, the agricultural heartland, the coal producers of Appalachia and so on -- is easy to convince that its livelihood is being stolen by Canada and Mexico.  The Trump voters are not seeing the whole picture, but in their own terms they're not entirely wrong.

Smoot-Hawley; Trump-Ross

Be honest now: did you really think that Donald Trump was going to play by the rules on trade and NAFTA?  If so, you've got quite a lot of company in Canada, particularly on the left of the political spectrum. Trade union economists and a good segment of the media were never big fans of the NAFTA deal to begin with, and not without good reason, given the havoc it created in Canada's manufacturing sector.  Many of them have viewed the possible collapse of the pact with equanimity, noting that the US tariffs that would come back into effect in a post-NAFTA world would be generally in the range of 2.5 percent -- regrettable, but entirely manageable.

So much for that.  Trump and his uber-geriatric Commerce Secretary, Wilbur Ross, have come up with the idea of levying much higher tariffs on the grounds of "national security",  starting with 25 percent levies on steel and 10 percent on aluminum. The targets of the tariffs, which include the EU and Mexico as well as Canada, are righteously angry.  In Canada's case the anger is partly based on the "national security" ruse, which Prime Minister Justin Trudeau has portrayed as "insulting", given the past history of the US and Canada fighting wars together. (Trudeau refrained from pointing out that Canada entered both World Wars years ahead of the US).

A further source for Trudeau's anger is that the US actually runs a trade surplus in steel with Canada, making it a very strange starting point for a trade war.  In any event, the Canadian government has responded with tit-for-tat tariffs of its own on a wide range of US products, including steel and (who knew?) maple syrup.

I haven't actually read Trump's "Art of the Deal".  I don't think this places me at any disadvantage in understanding his thinking, since he didn't actually write it.  It seems clear, though, that Trump sees his unpredictability as his key advantage in negotiations -- just ask Kim Jong-Un.  That unpredictability, however, is tactical rather than strategic.  One of the things that has to be recognized about Trump is that what he does largely reflects what he says.  During the election campaign he promised to do all manner of bizarre and reckless things, which the media (and the Republican Party) dismissed as so much hot air. It's now very clear that he meant every word, and as the second year of his term rolls on, he seems to be coming more emboldened by the day.

Media commentators in Canada in the last day or two have noted that Canada is the "junior partner" in the trade deal with the US.  Some have argued that this means that retaliating against Trump's tariffs, as the Trudeau government has done, will simply invite still more retaliation from Washington.  Responding to bullying by just sitting back and taking it is not a tactic that often seems to work.

In any case, there's no reason to think Trump will wait for an invitation.  Today he has tweeted about Canada's restrictive practices in agricultural trade, an issue that came up during the election campaign. It has to be said that Trump is on much firmer ground here than he is with steel.  The arcane "supply management" system in the Canadian dairy sector is one of the most egregious examples of "producer capture" to be found anywhere in the developed world, as anyone buying overpriced milk or eggs in Canada can attest.

Breaking up that system would be a big favour to Canadian consumers, but that aside, it's hard to see any upside to what looks more and more like a nasty trade war, the US against everybody. And we know from history how that's likely to end.