We’re nearing the anniversary (Dec. 5) of the Bank of Canada’s decision to stop its march back to a more normal policy setting. Stephen Poloz, the governor, has used the pause to gather his thoughts on this strange period of low-for-longer-and-longer-and-longer interest rates. His conclusions suggest that borrowing costs will stay low for longer yet.
But if Poloz is right, that won’t be a bad thing, which is a different spin on what you tend to hear about monetary policy these days.
Is AI disrupting the economy just like the steam engine and the computer chip did in previous eras?
Lawrence Summers, the Harvard economist who was an important figure in the administrations of Barack Obama and Bill Clinton, has popularized the notion of a “secular stagnation,” hypothesizing that interest rates are low because there are too few attractive investment opportunities away from bonds.
Others argue that the link between the unemployment rate and inflation has been severed, perhaps because globalization keeps costs in check, or maybe because central banks got so good at containing inflation that the public has become convinced that price increases will never exceed (or drop out of) the ranges policy makers have set.
All these ideas have merit, all are supported by evidence, and yet none are entirely convincing.
Interest rates are negative in much of Europe, despite unusually low unemployment rates; but in Canada, inflation is hovering around the central bank’s two-per-cent target, just as you’d expect given our high levels of employment and rising wages.
Are investors piling their money into government bonds, and thus pushing down interest rates, because they are pessimistic about the future, or is it because the aftermath of the Great Recession followed by the trade wars have made the short term too unpredictable?
Poloz has expressed doubts about these theories multiple times over the years. Now he’s gone beyond pointing out their flaws and offered a hypothesis of his own, supported by a 14-page research paper. Canada’s central bank governor wonders if the emergence of artificial intelligence, sometimes described as the fourth industrial revolution, is disrupting the economy just like the steam engine, electrification and mass production, and the computer chip did in previous eras.
“Could it be that a profound positive technology shock is supporting economic growth, holding back wage growth and inflation, and redistributing resources from the goods sector to the service sector?” Poloz asks in his paper, which he presented at a conference hosted by the Federal Reserve Bank of San Francisco on Thursday.
The great leaps forward had similar effects: workers were displaced; investor exuberance led to bubbles and busts; new types of jobs are created; productivity and the economy’s ability to create inflation-free growth increases; prices fall; debt rises, leading to a crash when asset values drop.
Not everything is the same. The pace of change sped up over time. There was a century between the introduction of steam power and the Victorian Depression, and it took about 50 years for electricity and assembly lines to go from brilliant ideas to the Roaring Twenties to the Great Depression.
The third industrial revolution lasted for about a generation starting in the 1970s, and brought booms and busts, including the Asian financial crisis of the 1990s. But there wasn’t a global depression. Poloz reckons that’s because Alan Greenspan, the chairman of the Federal Reserve, recognized the shift to computers had dramatically increased productivity even though data suggested otherwise. Rather than panic, Greenspan left interest rates unchanged, betting the economy’s newfound capacity to generate growth would offset inflation. He bet right.
Poloz thinks something similar could be happening now.
The data don’t show it, but that could be because statisticians haven’t figured out how to measure the digital economy. For example, companies describe renting cloud space as an expense, meaning one of the most important drivers of productivity in modern companies doesn’t show up in tallies of investment spending.
Poloz offered evidence that it took forecasters about five years to figure out what was happening in the 1990s. He reckons that future “backcasts” will paint a very different picture of the economy than the one that short-term forecasts have created here in the present.
Expect low for longer, but not much lower
The economy’s ability to generate inflation-free growth over the medium term increased by about 1.25 per in the 1995-2000 period, according to Poloz. If a similar shift happened now, economic growth and hours worked would increase markedly, and inflation would decelerate, prompting lower interest rates, according to simulations run through the Bank of Canada’s main forecasting model.
“There’s a good possibility that we will experience something similar (to the Greenspan period) over the next decade as the fourth industrial revolution unfolds,” Poloz said. “The prescription for monetary policy if that scenario plays out is likely to be very much like that of 1995 to 2005. That would mean keeping monetary policy neutral while inflation stays subdued and allowing growth to run, for this is a good way of providing upside potential to those negatively effected by new technology.”
All things equal, Poloz’s research suggests the Bank of Canada could be open to cutting interest rates even with inflation at target.
However, the other important lesson of the Greenspan era is what happens if interest rates stay too low for too long. Poloz was clear in both his paper and his speech that central banks should tolerate weaker inflation if lower interest rates would upset financial stability.
That’s certainly the case in Canada, where the levels of household debt remind many of the U.S. ahead of the financial crisis. The fourth industrial revolution may explain why central banks have been able to keep interest rates low, but there’s nothing in Poloz’s theory that suggest human behaviour has changed.
Our proven propensity to borrow as much as the banks will give us will keep the Bank of Canada from letting the economy run as hot as it might under different circumstances. Expect low for longer, but not much lower.