Fed to Trump: "you're right"

Ramping up his bully-boy campaign for lower interest rates last week, Donald Trump declared that "we don't have a Fed that knows what it's doing".  This week the Fed came remarkably close to admitting that the famously economics-illiterate Trump might just be right.

Minutes of the June FOMC meeting, released this week to coincide with Fed Chair Powell's Humphrey-Hawkins testimony, show that the Committee members are moving ever closer to pulling the trigger on the rate cut that the White House is demanding.  Well-known risks to the near-term outlook, such as the Trump-inspired trade wars, are just one of the top-of-mind issues. What is really striking is that FOMC members are coming to the realization that the economy just isn't working the way they thought it did.  Employment is continuing to grow almost ten years into the expansion with no sign of rising wage pressures and little evidence of an inflationary breakout. This sentence from the minutes sums it all up:

Several participants pointed out that they had revised down their estimates of the longer-run normal rate of unemployment and, as a result, saw a smaller upward contribution to inflation pressures from tight resource utilization than they had earlier. 

Sad as it is to admit it, that seems to be very much the point that Trump has been trying to make all along.  It's a stunning admission for the FOMC to make: the notion of an inevitable trade-off between unemployment and inflation, captured by the well-known Phillips Curve, has been a bedrock of policy-making for decades. Now, for reasons not yet fully understood, it no longer seems to apply.

Against this backdrop, Chairman Powell's testimony to Congress came very close to confirming that the Fed will cut its funds target when the FOMC meets at the end of the month. Even at the June FOMC meeting, some members were ready to consider a rate cut, and Powell noted this week that in the interim, uncertainties about trade and the global economy had continued to weigh on the US outlook.  While affirming that the economy remains solid, Powell left little doubt that the Fed would use the tools at its disposal to keep the expansion going.

What does all this mean for the Bank of Canada? The Bank released its Monetary Policy Report this week, and its upbeat tone is in marked contrast to the more cautious mood at the Fed.  While fully acknowledging the trade-related risks, the Bank seems fully convinced that the slow patch endured by the economy at the start of this year is over.  It is forecasting higher growth through next year, in contrast to the slowdown looming south of the border. 

Deputy Governor Carolyn Wilkins -- who seems very much to be the next Governor-in-waiting -- tried to portray this not as a divergence between the two economies, but as a convergence, in the sense that both countries are reverting to their trend rates of growth -- Canada from below, the US from above. Be that as it may, the monetary policy implications look clear, assuming the Bank's analysis is right: there is little scope for the Bank to match any Fed rate cut in the near term.  Considering that Canadian CPI is either at the 2 percent target (if you look at the core rates) or well above it (if you look at headline CPI); and considering further that wage growth is now well above inflation, at 3.8 percent year on year, the case for a rate cut looks weak regardless of what may happen at the Fed.

And yet.....the ability of the Bank of Canada to set policy independent of the Fed is always severely constrained, given the relative size of the two economies and the strong linkages between them.  The exchange rate usually tells the tale and eventually forces the Bank's hand.  Markets have taken note of the apparent policy divergence and have pushed the Canadian dollar to a nine-month high this week, with further gains on the horizon.  This may be helpful in bringing inflation under control, but it will soon start to weigh on real activity, especially if markets come to believe that the policy divergence will be long-lasting.  Departing Governor Stephen Poloz may not have to cut rates before he leaves at the end of the year, but his successor is likely to face some big calls early in her or his term in office.