Canadian Blues. When will they learn?

The Bank of Canada announced a surprise quarter-percentage-point cut to its key interest rate Wednesday – a move it calls “insurance” against the potentially destructive effects of the oil price collapse.

The reduction in the bank’s overnight rate to 0.75 per cent from 1 per cent – its first move since September, 2010 – comes as a precipitous drop in the price of crude slams Canada’s oil-dependent economy.

“The considerably lower profile for oil prices will be unambiguously negative for the Canadian economy in 2015 and subsequent years,” the bank warned in its latest monetary policy report, released Wednesday.

You would think, then, that the oil price increases that took place from the early 2000s on would have been unambiguously positive for the Canadian economy.

Note, however, that from that point on real growth came down, at the same time inflation showed frequent spikes. That´s the outcome expected from negative supply shocks. Keeping NGDP evolving close to the trend path (see below) was the best solution.

Canadian Blues_1

Canadian Blues_2

This is also one clear indication that it´s no good to reason from a GDP component change (net exports in this case). Instead of reasoning from Y=C+I+G+(X-M), focus on MV=PY

Nevertheless, all the while (at least up to mid-2008), NGDP growth remained on trend. After mid-2008, monetary policy (maybe because it relentlessly pursued the 2% inflation rate target) has fallen short, and increasingly so!

Canadian Blues_3

The BoC should come out and say that their target will be to take back the economy to the path it was in up to 2011, when rising oil prices (yes, oil again) induced a spike in headline inflation and the BoC allowed spending growth to “shift-down”

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