Boyd Erman
Globe and Mail Update

After a year of making it easy by telling the market exactly what the Bank of Canada would do with borrowing costs by giving a commitment to keep them at emergency lows, Governor Mark Carney has rapidly switched tacks. The country’s top central banker is now confounding those who would try to predict exactly how fast interest rates will rise by refusing to give explicit guidance.

Yesterday’s quarter-point increase in the benchmark central bank rate and the accompanying statement show that the kind of transparency markets get from Mr. Carney as borrowing costs go up in coming months is going to be very different than what they have become used to over the first part of his tenure, when rates dropped to record lows and stayed there.

In this statement, Mr. Carney is being open but not predictable. He is laying out the parameters he is watching and leaving it to markets to try to figure out what that will mean for rates. It’s an education for investors and analysts, because this is the first time they have seen Mr. Carney raising borrowing costs.

“It’s going to be more fun being the central banker in this environment than being a forecaster,” said Mark Chandler, a rates strategist at RBC Dominion Securities who predicts “a whole bunch of angst” before every Bank of Canada rate announcement in coming months.

Just as the explicit commitment to keep rates low served a purpose by giving an uncertain economy some certainty, the new move to the other end of the predictability spectrum gives Mr. Carney the flexibility he needs to deal with a stop-and-go rebound in growth.

The economy posts a couple of hot quarters and inflation ticks up? Fine, a quarter point tighter it is. But then we wait and see.

This isn’t a normal recovery, so there’s no sign of the central bank’s normal language in a tightening cycle. Usually, there is wording foreshadowing a steady move higher, along the lines of “some further reduction of monetary stimulus will be required,” to quote a 2005 rate hike announcement. This time, the guidance is that “any further reduction of monetary stimulus would have to be weighed carefully against domestic and global economic developments.”

With that, Mr. Carney has established himself as neither hawk nor dove, just a pragmatist who watches the data and the markets and reacts.

Already, there are signs that the new strategy is a success. The market is re-evaluating its belief that more rate cuts are a sure thing.

Read more at:
www.theglobeandmail.com

More about forecasting interest rates:

Economists use a variety of techniques to forecast interest rates. The most basic is to use economics and history as a guide and to make a judgement about what an appropriate level of interest rates and their future course given the state of the economy and important economic variables. Since most economists disagree on how the economy works or what economic history means, this is more difficult than it seems.
See Schools of Economic Thought.

Quantitative economic statistical techniques called “econometrics” attempts to model the economy using mathematical and statistical relationships. A comprehensive model of the economy might have hundreds of equations and many variables. The problem with these techniques is that while they might have a “high explanatory power” or be “robust” historically against “back-tested” data after the fact, they are very poor at explaining the future before the fact.
See Econometric Techniques.

The reason for this inaccuracy is simple. Interest rates reflect human behaviour which is highly complex. This complexity has been compounded by the internationalization of economies and the financial markets. The direction of Canadian and U.S. interest rates is partially set by those of other countries, particularly Germany and Japan. Even governments miss their interest rate forecasts and they have control over their countries’ monetary and fiscal policy.

More about forecasting interest rates

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Tags: Bank of Canada, Econometric Techniques, Economic Thought, interest rates