Why the differing rate decisons?

Canadian and U.S. central banks share similar concerns on the economy, but chose different paths to stability last month - RBC's Eric Lascelles explains why, and what this means for Canadian investors

Ruth Saldanha 27 August, 2019 | 1:43AM

 

 

Ruth Saldanha: Last month, the U.S. Federal Reserve and the Bank of Canada made rather different rate decisions. The Fed cut rates for the first time in a decade, while the Bank of Canada did not. Both acknowledged decent domestic economic conditions but also expressed concerns about slowing global growth. So, why the differing rate decisions? And what does it mean for Canadian investors? RBC Global Asset Management's Chief Economist Eric Lascelles is here with us today to talk about it.

Eric, thank you for being here today.

Eric Lascelles: Thank you for having me.

Saldanha: First up, why did the Fed cut rates? Was it just an insurance cut?

Lascelles: Well, certainly, part of it was an insurance cut. And so, I suppose when I think about that, there is some foundation in the economy, global growth is slowing, and protectionism is mounting. And so, these are drags. And that's always a motivator for central banks. And they would equally say that inflation expectations are a little bit low. But in the end, it seems to me that a big part of this was very much an insurance cut. Looking at the different scenarios that could play out over the next year or two, very much focusing on the notion that the most likely scenario is still growth and growth doesn't obviously scream for rate cuts, but also acknowledging this larger than usual downside risk, this risk of recession, this risk of greater protectionism, and delivering a few so called insurance cuts essentially is a means of perhaps steering that off or helping to manage that risk given that it's no longer trivial.

Saldanha: Having said that, in similar circumstances the Bank of Canada decided to hold. So, why did that happen?

Lascelles: Well, that's an interesting thing. And so, let's not pretend the two economies are identical, but they're often very similar. And as you mentioned off the top, there are some very specific similarities right now in terms of domestic economies that aren't too badly off but confronted by protectionism and slowing growth. And so, it is interesting that these central banks for the moment, at least are going in different directions. And in the Bank of Canada's case, it really comes down to they don't seem to be playing the same kind of scenario analysis that the Federal Reserve is doing. And so, the Bank of Canada says the most likely scenario is another a year or two of growth, reasonable growth at least doesn't require cuts. And so, they're not doing it. To be honest, they also have a larger than usual downside risk. There is very much a scenario in which they will have to and recessions brew and these sorts of things. But that's just not their focus right now. So, it's more of a philosophical difference of the base case scenario versus weighing all of the scenarios when you look at these differences. And my suspicion is, in the end, the two central banks won't be quite as different in their actions as perhaps their words today are currently suggesting.

Saldanha: In what circumstances do you see the Bank of Canada cut rates?

Lascelles: To my eye, the Bank of Canada isn't all that far from cutting rates. So, of course, we've seen the U.S. Federal Reserve already do that, with several more likely in store. The Bank of Canada has given no such message. But my sense is, if we do continue to see the global economy slow over the next few months, which is entirely conceivable, in fact, probably more likely than not, my suspicion is we could find the Bank of Canada that does work its way towards a rate cut perhaps towards the end of the year, just recognizing that the environment isn't as strong as they'd hoped it would be but also recognizing that their peers have been going in a very different direction. Of course, we focus on the Fed, but quite a number of central banks around the world have recently pivoted toward easing.

Saldanha: Finally, what should investors do in these circumstances?

Lascelles: Well, that's a great question. And that's a tough one. Of course, investors are invested in many different asset classes. I think perhaps the best approach that we take is one really that acknowledges that scenario analysis the Fed is looking at. And so, the challenge is one in which it probably is still slightly more likely than not that we get okay growth over the next year. But you then have this other scenario, which is materially worse. And so, we're straddling that to some extent. And so, for instance, we are taking, and I suppose, recommending taking less risk than was once the norm. We don't own as many stocks, as many equities as we once did. We hold more fixed income, more cash than a year or two ago, but this has not been nor do we think it needs to be a head for the hills type of moment, just in the sense that bond yields are very low, it's hard to get a reasonable return out of that. In the long run, both in a general sense and given valuations today, we think the stock market actually returns more. And so, it's one in which very much still exposed to risk, but less than we were a few years ago, and we think that's a reasonable balance, given the downside and the upside risks that exist today.

Saldanha: Thank you so much for joining us today, Eric.

Lascelles: My pleasure.

Saldanha: For Morningstar, I'm Ruth Saldanha.

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Ruth Saldanha  Ruth Saldanha is Senior Editor at Morningstar.ca