Here's what Tiff Macklem and Kevin Warsh get wrong about productivity and interest rates, says Desjardins
Bank of Canada governor Tiff Macklem and United States Federal Reserve chair nominee Kevin Warsh are misinterpreting the effect of productivity on the economy and what it could mean for interest rates , says a Desjardins Group economist.
“The problem that both of them make is that they are tying just one variable, which is the potential of the economy, to where interest rates should be set,” Royce Mendes, managing director and head of macro strategy at Desjardins Group , said.
That misinterpretation is leading them to potentially make mistaken estimates of the neutral rate and, consequently, decisions around interest rates. Canada’s neutral rate, which is calibrated to neither stimulate nor depress economic growth, ranges from 2.25 per cent to 3.25 per cent.
Warsh, in front of a U.S. Senate confirmation hearing last week, said an artificial-intelligence-led productivity boom won’t lead to higher inflation, thereby leaving room to cut the Fed’s benchmark interest rate.
However, Mendes, in a note on April 22, said economic theory has established that productivity increases when capital spending rises, pulling along consumers who end up saving less. Increased spending spurs demand and inflation typically comes along for the ride.
Macklem, during a speech earlier this year, said lower productivity leads to weak growth, so cutting interest rates can risk “stoking future inflation” and delaying “needed structural change.”
But Mendes said a lower productivity scenario or a lower potential output scenario are not sufficient reasons to expect lower interest rates to stoke inflation. He said the problem regarding rate setting is which version of the neutral rate is being used — at least in today’s environment.
The benchmark lending rate is currently 2.25 per cent, and he said policymakers have made a few references to their belief that rates are in stimulative territory.
The Bank of Canada will release its annual estimate of the neutral rate along with its latest interest rate decision on Wednesday.
Mendes isn’t expecting any changes to the central bank’s neutral rate policy, but said it should implement a different regimen to determine what is the appropriate neutral rate as well as what is stimulative and what isn’t.
“What they forecast is a very, very long-term concept of neutral, which is almost useless for calibrating where policy should be today because there are two ways to measure neutral: a short-run neutral and a long-run neutral,” he said.
Because policymakers take a long-term view of neutral, he said they “look through” seismic economic events such as the tariff war with the U.S. and its effects on business investments and productivity and a contraction in population growth.
“If you look at those two big factors, population growth and productivity growth, both of them are extremely weak in the current environment, and both would suggest that the short-term neutral rate is below whatever the estimate of the long-term neutral rate is,” he said, adding that a lower neutral rate could lead to lower interest rates.
Mendes said the war in Iran has added another complication to calculating rates since it has fed rising inflation expectations, putting the Bank of Canada in a tough position between balancing the needs of the economy and keeping inflation under control.
He said central bankers shouldn’t rush into anything when they meet on Wednesday.
“I will tell you that right before the conflict broke out in the Middle East, we were very close to changing our call for the Bank of Canada to cut rates,” he said. “That derailed our plans because of this energy price shock.”
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