Divergence in Monetary Policies (Part I)

If you have been following the performance of the Canadian and US economies as of late, you will notice that the two countries are at pivotal point in their relations with each other. It’s important to mention that the yield on a 10-year government bond for both countries has increased significantly in recent months; with the US interest rate currently sitting at 2.55% and the Canadian interest rate at 1.82% (Please note: the significance of the ten-year treasury bond as an economic indicator will be discussed in a subsequent post) The third quarter of 2016 was notably the US economy’s best performance in the past two years while the story in Canada hasn’t been analogous in the least. In fact, the Canadian economy has been stagnating. The unemployment rate in the US is currently sitting at 4.6%, and in contrast, the Canadian unemployment rate is just under 7%; with the most generous quote putting this number at approximately 6.8%.


However, this is not just a problem of restoring full employment, there is also a serious lack of growth in the Canadian economy. This leads us to question the proper role of monetary policy. Investopedia defines monetary policy as


“… the actions of a central bank, currency board or other regulatory committee that determine the size and rate of growth of the money supply, which in turn affects interest rates. Monetary policy is maintained through actions such as modifying the interest rate, buying or selling government bonds, and changing the amount of money banks are required to keep in the vault (bank reserves).”


Quantitative easing is an example of a monetary policy, albeit an unconventional one, that central banks utilize in order to increase the money supply and decrease interest rates. 


The rationale is that the increase in money supply in conjunction with a fixed amount of goods available for sale should theoretically result in an increase in inflation. Here’s the catch, John Maynard Keynes warned us that “printing money isn’t enough, if it isn’t being spent it can’t create inflation."


The ideal target of inflation for both countries is 2%. The reason why the inflation target is not zero is because consumers would have no incentive to spend in the current period, as they know prices would not be going up in a future period. This would cause a decrease in demand; which in turn would lead to a decrease in prices. This is referred to as price deflation and is an indicator that a recession is on its way, that is, if a country is not already in one. Therefore, inflation targeting or inflation control is the primary function of the effectiveness of monetary policy in Canada and the US. Unfortunately, both countries are not meeting their inflation targets. The current inflation rates in both countries are 1.2% and 1.7% respectively. Canada saw a significant decrease in inflation from October (1.5%) to November (1.2%).  This is good news for the US; not only is its current inflation rate higher than Canada’s but its inflation rate has been steadily going up since an annual low in July.  


Economic monitoring can also be done via a measurement commonly referred to as Terms of Trade. It represents the price of exports of a country relative to the price of its imports. A decline in the terms of trade means the price of exports falls relative to imports and results in a decreased ability to import in the short run, while an increase would have the opposite affect. The current change in the terms of trade between Canada and the US was initially caused by the oil price shock. It’s easy to see how Canada being a net exporter of commodities and the U.S. being a net importer would result in the impact of terms of trade for the two economies to be consistently antithetical. A long run decline in terms of trade results in lower living standards.   


As a result, the differing unemployment and inflation rates along with reversed terms of trade, (US TOT rising while Canadian TOT falling) have led to a narrative or theme of “policy divergence” to describe if not explain the atypical behaviour of the central banks of both countries going their own way. Consequently, the US Federal Reserve has increased its benchmark interest rate and plans further increases throughout 2017. Canada, on the other hand, has held its central banks benchmark and will most likely continue to do so if it doesn’t decide to lower its rate.


Kaha Haji-Mohamed

Works Cited

Picture titled, "United States Federal Reserve System", taken by Kurtis Garbutt on November 20, 2011, obtained through Creative Commons (https://flic.kr/p/aLbWnT