PrefBlog

Mixed news on the economy:

On Tuesday, Statistics Canada said real gross domestic product was unchanged in the fourth quarter of 2022 after five consecutive quarters of growth.
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After two quarters of record inventories, businesses accumulated less inventories in the fourth quarter, weighing significantly on real GDP growth.

Real business investment also declined for a third consecutive quarter as higher interest rates weakened housing investment in 2022.

In December, the economy contracted by 0.1 per cent as goods-producing industries declined.
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A preliminary estimate from Statistics Canada suggests the economy bounced back in January, posting 0.3 per cent growth in real GDP.

Last month, the economy added 150,000 jobs, suggesting there’s still steam on the hiring front.

Economic models are getting more complicated:

But traditional models ignore income and wealth inequalities and assume that what’s good for the typical consumer, as defined by the models, must be good for the broader economy.

A newly developed class of quantitative models is particularly suited to guiding central bankers across this new monetary policy territory, in which the wealth and income distributions are a central consideration. Known as HANK models, they combine heterogeneous agent models (macroeconomists’ workhorse framework for studying income and wealth distributions) with New Keynesian models (the basic framework for studying monetary policy and movements in aggregate demand).

HANK models impart new lessons about redistribution and the heterogeneous effects of monetary policy and shed new light on traditional central bank objectives of inflation control and output stabilization. Here are four broad lessons, and some preliminary thoughts, on how HANK models may illuminate our current high-inflation environment.
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The relative size of indirect versus direct channels depends mainly on the aggregate marginal propensity to consume (MPC), which measures how much of a household’s increase in income gets spent and how much is saved. In traditional models, which try to predict the impact of monetary policy on the typical consumer, the MPC is tiny, and consequently the indirect channels are insignificant. HANK models, instead, are built to be consistent with empirical evidence on consumption and saving behavior. Their aggregate MPC is roughly 10 times larger, and thus the various indirect effects dominate the transmission mechanism.
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Many channels of monetary policy have divergent, and sometimes opposing, effects on different households. For example, the direct effects of interest rate changes depend on households’ balance sheets: rate cuts benefit debtors, whose interest payments decrease (such as households with adjustable-rate mortgages) and hurt savers, whose interest income falls. Monetary policy also has heterogeneous effects through its impact on inflation. First, inflation benefits households with lots of nominal debt that is revalued downward. Second, prices rise more for some goods than for others, and different households consume these goods in unequal proportions. Finally, the indirect effects of monetary policy on household disposable income are uneven because some households are more exposed to fluctuations in aggregate economic activity than others.
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By introducing income and wealth inequality, HANK models reestablish a strong link between the two, showing how monetary policy leaves consequential “fiscal footprints.” When the central bank raises interest rates, the treasury’s borrowing costs increase, and the increase must be funded by raising taxes or lowering expenditures, now or in the future, or through future inflation. In HANK models, the details of how and when the government makes up this fiscal shortfall, and which households bear the burden, have a tremendous influence on the overall effects of interest rate hikes.
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Studies of optimal monetary and fiscal policy in HANK models agree that the benefits of aggregate stabilization are dwarfed by the gains from directly alleviating hardship. Optimal policies in HANK models almost always favor redistributing toward hand-to-mouth households in downturns.

One may be tempted to read this as endorsement of using monetary policy to share prosperity and mitigate adversities. But monetary policy is a blunt tool for redistribution or insurance. HANK models tell us that fiscal policy is likely better suited for this task because it can be targeted more precisely to those in need of support.

The BoC has released a Staff Analytical Note by Ramisha Asghar, James Fudurich and Jane Voll titled Firms’ inflation expectations and price-setting behaviour in Canada: Evidence from a business survey:

Implementing effective monetary policy could be more challenging for central banks if firms expect inflation to be high. Tightening monetary policy slows price growth by reducing overall demand, slowing cost increases and raising competitive pressure on firms. But high inflation expectations may encourage large price increases if firms believe that cost growth will remain high after a tightening of monetary policy. If left unchecked, high inflation and elevated inflation expectations could cause a wage-price spiral, anchoring high inflation with harmful economic consequences.1 Because of this risk, understanding whether high inflation expectations are influencing firms’ price-setting behaviour is critical to know for an inflationtargeting central bank.

We investigate whether the recent period of high inflation has changed how Canadian firms set prices for their products and services.
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We find little evidence that firms’ price setting is directly based on high inflation expectations. However, we find that widespread growth in input prices during a period of strong customer demand and reduced competition may have contributed to price increases that were larger than usual. This may explain some of the inflationary pressure observed in 2021 and early 2022. Furthermore, early evidence suggests that in the second half of 2022, price-setting behaviour was gradually returning to pre-pandemic practices, supporting a path for inflation to return to the inflation-control target range. However, the risk remains that high inflation may start to be reflected directly in output prices, which would make it more difficult for monetary policy to reduce inflation.

OMERS had a good year … as long as their valuation of private equity is accurate!

The return OMERS reported for 2022 fell short of an internal benchmark of 7.2 per cent that was set at the end of 2021, when market conditions looked rosier. But it compares favourably with widespread investment losses across the sector after stock and bond prices plunged in the first half of last year.

Last week, Quebec-based pension giant Caisse de dépôt et placement du Québec reported a 5.6-per-cent loss in 2022. On average, Canadian defined pension plans performed much worse, with an average annual loss of 10.3 per cent, as measured by a typical mix of publicly held stocks and bonds tracked by Royal Bank of Canada’s RBC I&TS All Plan Universe.
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Over 10 years, OMERS has averaged returns of 7.5 per cent, after expenses, which beat its multiyear benchmark of 7.4 per cent. The fund had assets of $124.2-billion as of Dec. 31, up from $119.5-billion at the end of June.
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Though OMERS suffered losses in its equity and bond portfolios, which fell 5.4 per cent for the year, they were offset by returns from its investments in private assets, which include infrastructure, real estate and private equity.

Private equity investments returned 13.7 per cent, ahead of an internal benchmark of 11.2 per cent, and the companies OMERS invests in through the portfolio broadly held their valuations during the year. Infrastructure investments gained 12.5 per cent, beating a 7.7-per-cent benchmark. And real estate investments gained 13.6 per cent, topping a 7.1-per-cent benchmark.

Canaccord shareholders want more money:

A special committee of Canaccord Genuity Inc.’s CF-T +0.79%increase
board of directors has said a bid to take the independent Canadian investment bank private is too low, after a group of the company’s senior leaders officially launched the takeover attempt early Monday.

More than 50 members of the company’s management team, including chief executive Dan Daviau and board chair David Kassie, first announced plans last month to collectively launch the takeover bid, for $11.25 a share. The management group’s offer values the company at roughly $1.13-billion, despite a subsequent valuation prepared by Royal Bank of Canada RY-T +0.60%increase
for the special committee that found Canaccord to be worth significantly more.

While the offer price represents a nearly 42-per-cent premium over the 20-day average price of Canaccord’s stock as of Jan. 6 – the last trading day before the management group announced its intention to take the company private – it is roughly 32 per cent below Canaccord’s November, 2021, value of $16.52 a share. Canaccord stock has been consistently trading above the proposed offer price since the planned takeover bid was made public on Jan. 9, suggesting investors expect the initial offer price to rise.

My Facebook feed lit up today with people as far south as Montana, Wyoming and Illinois posting glorious, once-in-a-lifetime shots of the Aurora Borealis:

Pictures shared online showed a bright green glow that seemed to be radiating from the grassy hilltops of Scotland. Others showed pink shades filling the sky behind the Neolithic site of Stonehenge in England and above the sharp cliffs on the coast of Ireland. The northern lights were seen across Sussex and Wales; above a cemetery; and from bedroom windows, backyards, a university and even planes.

It is quite common for northern lights to be spotted in Scotland and parts of Northern England, but it is much rarer to see them in southern parts of England. The display on Sunday was one of the best in a very long time, according to the BBC’s weather watchers, a crowdsourced weather club.
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The northern lights are produced by charged particles from the sun that hit Earth’s magnetic field. They are generally visible by the poles, but if the geomagnetic storm is particularly strong, the particles can travel farther south, experts told The New York Times this year.

The European Space Agency said that Sunday night, an expulsion of material from the sun arrived at Earth just as a high-speed solar wind stream whipped through the space around our planet.

Here’s one of my favourites, taken last night in Red Lake, Ontario:

So American inflation fears picked up:

Inflation remains stubbornly elevated and unexpectedly picked up in January, a fresh reading of the Fed’s preferred index showed, underscoring the daunting challenge facing central bankers as they try to wrestle price increases back to a normal pace.

After six months of more or less consistently cooling down, the Personal Consumption Expenditures price measure climbed 5.4 percent in January from a year earlier, an unexpected pickup from 5.3 percent the prior month and substantially more than the 5 percent economists had expected.

Even after stripping out food and fuel prices, both of which jump around a lot, the price index climbed by 4.7 percent in the year through last month — also a pickup, and more than expected in a Bloomberg survey of economists.
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Personal spending, which spans both goods and services, climbed by 1.8 percent in January. That compared to a slight 0.1 percent decline in December, and was more than the 1.4 percent increase that economists had anticipated. Even after adjusting for quick inflation, consumer spending rose at a hearty pace last month.

And there was some cheerful historical data put together:

In research released on a day when inflation data showed an unexpected spike, the authors found that over 16 episodes of “disinflation” engineered by central banks in the United States, Germany, Canada and the United Kingdom, “we find no instance in which a significant central bank-induced disinflation occurred without a recession.”

The researchers included Brandeis International Business School professor Stephen Cecchetti, who is a former top economist at the Bank for International Settlements; Michael Feroli, chief economist at J.P. Morgan; and Columbia Business School professor Frederic Mishkin, who is a former Fed governor and long-time research collaborator with former Fed Chair Ben Bernanke.

The findings were presented on Friday at a conference organized by the University of Chicago Booth School of Business, and drew pushback from Fed officials who reviewed and commented on it.

“I don’t see that we have to have this trade-off between labour and price stability. I am greedy,” Cleveland Fed President Loretta Mester said in remarks to CNBC.

In a paper issued in response to the research, she argued that the recessions associated with past disinflation may have been the result of central banks tightening policy more than necessary, not that a recession was needed to bring price increases into line.

“The implication is that policy-makers need to be attentive to the lagged effects of policy actions as they bring inflation down,” Mester said.

And the BoC has released a Staff Analytical Note by Cyrus Minwalla, John Miedema, Sebastian Hernandez and Alexandra Sutton-Lalani titled A central bank digital currency for offline payments:

• An offline central bank digital currency (CBDC) is a digital complement to bank notes. It enables transactions without the internet while still allowing online purchases when internet connectivity is available.
• The design of an offline CBDC depends on the duration of the offline period. Intermittent offline refers to a temporary internet outage, such as that caused by a failure of telecommunications infrastructure. Extended offline refers a lengthy and indeterminate outage, likely caused by a storm or other weather event. It also refers to the situation in remote regions that do not have reliable or affordable internet.
• Regardless of the length of the offline period, an offline CBDC must be spent or transferred using a digital device—for example, a smartphone with a custom application, or a purpose-designed universal access device (UAD).
• An offline CBDC offers users benefits such as enhanced resilience and better accessibility features. It could also preserve the privacy typically associated with offline payments.
• To minimize the risk of theft or loss, an offline CBDC may require secure hardware with controls to guard against unauthorized tampering, as well as a user-specific personal identification number (PIN), password or biometric authentication stored on the device itself.
• A balance must be struck between compliance, security requirements and user needs. A suitable balance may be defined by optimally selecting limits on holdings, transaction amounts and the duration of offline functionality. Adopting a security posture in terms of limits, controls and functionality, where risks are sufficiently mitigated, is still a challenge for technology available today.

The BoC has released a working paper by Jonathan Chiu, Emre Ozdenoren, Kathy Yuan and Shengxing Zhang titled On the Fragility of DeFi Lending:

We develop a dynamic model of decentralized finance (DeFi) lending that incorporates two/these key features: 1) borrowing and lending are decentralized, anonymous, overcollateralized and backed by the market value of crypto assets where contract terms are pre-specified and rigid; and 2) information friction exists between borrowers and lenders. We identify a price-liquidity feedback: the market outcome in any given period depends on agents’ expectations about lending activities in future periods, with higher price expectations leading to more lending and higher prices in that period. Given the rigidity inherent to smart contracts, this feedback leads to multiple self-fulfilling equilibria where DeFi lending and asset prices move with market sentiment. We show that flexible updates of smart contracts can restore equilibrium uniqueness. This finding highlights the difficulty of achieving stability and efficiency in a decentralized environment without a liquidity backstop.
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Decentralized finance (DeFi) is an umbrella term for a variety of financial service protocols and applications (e.g., decentralized exchanges, lending platforms, asset management) that operate on blockchain technology. They are anonymous permission-less financial arrangements implemented via smart contracts — immutable, deterministic computer programs—on a blockchain that have been designed to replace traditional financial intermediaries (TradFi)
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The growth of decentralized finance has been substantial since the “DeFi Summer” of 2020. According to data aggregator DeFiLlama, the total value locked (TVL) of DeFi had risen to 230 billion U.S. dollars as of April 2022, up from less than one billion two years prior to that time. As DeFi grows in scale and scope and becomes more extensively connected to the real economy, its vulnerabilities might undermine financial-sector stability (Aramonte, Huang, and Schrimpf (2021)). As a result, policymakers and regulators have raised concerns about the implications of DeFi for financial stability (FSB 2022; IOSCO 2022).2 Yet formal economic analysis of this issue remains very limited. In this paper, we examine DeFi lending protocols—an important component of the DeFi eco-system—and the sources and implications of their instability. For example, DeFi lending is much more volatile than traditional lending.3 In addition, Aramonte et al. (2022) argue that DeFi lending generates “pro-cyclicality,” the co-movement between crypto prices and lending activities.
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In this paper, we study sources of fragility in DeFi lending caused by several of its fundamental features. These features are informational frictions, such as asymmetric information about collateral quality, oracle problems, and rigid contract terms. We demonstrate the inherent instability of DeFi lending that results from price-liquidity feedback exacerbated by informational frictions, leading to self-fulfilling sentimentdriven cycles. Stability requires flexible and state-contingent smart contracts. To achieve that end, a smart contract may take a complex form. Such a contract also requires a reliable oracle to feed realtime hard and soft information from the off-chain world. Alternatively, DeFi lending could abandon complete decentralization and re-introduce human intervention to provide real-time risk management— an arrangement that would force the protocol to rely on a trusted third party. Our finding highlights a trilemma faced by DeFi protocols: the difficulty involved in achieving simplicity in smart contracts and stability in asset prices while maintaining a high degree of decentralization.

The BoC has published a paper by Martin Kuncl and Dmitry Matveev titled The Canadian Neutral Rate of Interest through the Lens of an Overlapping-Generations Model:

The neutral rate of interest is an important concept and communication tool for central banks. We develop a small open economy model with overlapping generations to study the determinants of the neutral real rate of interest in a small open economy. The model captures domestic factors such as population aging, declining productivity, rising government debt and inequality. Foreign factors are captured by changes in the global neutral real rate. We use the model to evaluate secular dynamics of the neutral rate in Canada from 1980 to 2018. We find that changes in both foreign and domestic factors resulted in a protracted decline in the neutral rate.
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The biggest domestic contributors to the neutral rate change were the two demographic factors. Firstly, higher domestic savings due to longer longevity contributed -83 bps and -34 bps to the R∗ change in the high- and the low-elasticity case, respectively. Secondly, the reduction in TLI [Trend Labour Input] growth that implies lower investment and borrowing of young households contributed by -75 bps and -34 bps to the R∗ change in the high- and low-elasticity case, respectively.

The New York Fed updated its Corporate Bond Market Distress Index (CMDI):

• Corporate bond market functioning appears healthy, with the overall market-level CMDI remaining stable around its historical 30th percentile.
• Market functioning in the investment-grade segment remained below its historical 75th percentile in February.

PerpetualDiscounts now yield 6.25%, equivalent to 8.12% interest at the standard equivalency factor of 1.3x. Long corporates yielded 5.06% on 2023-2-10 and since then the closing price has changed from 15.03 to 14.69, a decline of 226bp in price, with a Duration of 12.32 (BMO doesn’t specify whether this is Macaulay or Modified Duration; I will assume Modified) which implies an increase in yield of about 18bp since 2/10 to 5.24%, so the pre-tax interest-equivalent spread (in this context, the “Seniority Spread”) has widened to about 290bp from the 270bp reported February 15.

TXPR closed at 576.56, down 0.73% on the day. Volume today was 1.51-million, second-highest of the past 21 trading days.

CPD closed at 11.56, down 0.26% on the day. Volume was 157,140, second-highest of the past 21 trading days.

ZPR closed at 9.54, down 0.94% on the day. Volume was 440,170, highest of the past 21 trading days.

Five-year Canada yields were were up sharply to 3.62% today.

The pundits have, as always, a glib explanation:

U.S. and Canadian stocks posted their worst performance of the year on Tuesday, with the main benchmarks ending down as investors interpreted a rebound in U.S. business activity in February to mean interest rates will need to stay higher for longer to control inflation.

For the S&P/TSX Composite Index, S&P 500 and Nasdaq Composite, it was their third session in a row closing lower, while the decline in the Dow Jones Industrial wiped out its gains for 2023.

The falls came after the S&P Global Purchasing Manufacturer’s index, which reflects business activity in the United States, returned to expansion for the first time in eight months in February. The 50.2 reading, up from 46.8 in January, was buoyed by a robust services sector, according to a survey.

The report added to a recent slew of economic data which has painted a picture of a resilient economy, which continues to perform against a backdrop of multiple rate-rises by the central bank in 2022 aimed at tamping down inflation.

With inflation still far from the Fed’s 2% target, and the economy retaining much of its vigor, money market participants have been revising upwards where they see the Fed fund rates peaking – currently at 5.35% in July and staying near those levels throughout the year.

And Canadian inflation was … OK:

Canada’s annual inflation rate eased more than expected to 5.9 per cent in January due to a so-called base-year effect, even as food and mortgage interest costs continued to soar, Statistics Canada data showed on Tuesday.

Analysts polled by Reuters had expected annual inflation to edge down to 6.1 per cent from 6.3 per cent in December. Month over month, the consumer price index was up 0.5 per cent, again lower than analysts’ forecast of a 0.7 per cent gain after a 0.6 per cent decline in December.

Statscan noted that the annual rate was impacted by downward pressure from the base-year effect of January 2022, when prices had risen amid Russia-Ukraine tensions as well as supply chain disruptions.
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Mortgage interest costs rose 21.2 per cent annually in January, the largest increase since 1982, while food prices rose 10.4 per cent, slightly faster than the 10.1 per cent in December.

The average of two of the central bank’s core measures of underlying inflation, CPI-median and CPI-trim, came in at 5.1 per cent compared with 5.3 per cent in December.