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Federal Reserve statements, wobbly stock markets and Frankenstein politics

09/23/2011 by Alex Carrick, RCD Canadian Chief Economist

As further signs of current uncertain times, Canada’s retail sales in July fell 0.6% from the month before, according to Statistics Canada, and the nation’s leading indicator index in August stalled out for the third month in a row.

The retail sales decline was rooted in the auto sector, while the leading indicator index weakness was concentrated in the housing sector and the stock market. 

Stock markets had been on a falling trend since April, but they nose-dived based on a particular comment contained in the latest interest rate announcement from the Federal Open Market Committee (FOMC) of the U.S. central bank.   

The Federal Reserve’s FOMC establishes interest rate policy based on the broad economic outlook. According to the FOMC, the economic outlook is now judged to contain “significant downside risks”.

It was the addition of the word “significant” versus the previous month’s assessment of “downside risk” that had such a negative impact. Statements by central bankers are combed and parsed for every nuance of meaning.

The good news, if it can be called such, is that the Fed has now committed to keeping the federal funds rate near zero percent through at least mid-2013.

The Fed will also adopt a strategy known as a “twist”. It will buy long-term bonds and sell short term notes in order to bring better balance to the yield curve – the spread between usually higher long-term rates and usually lower short-term rates.

The intent is to provide more stimulus for borrowing and investing by making money cheaper over an extended period of time. However, private sector borrowing costs do not always match up with what the public sector has to pay.

There are two major storm centers buffeting world economic prospects: 1) worries about the solvency of certain nations and banks in Europe, plus potential domino effects; and 2), the U.S. deficit problem made seemingly unsolvable by political rigidities. 

Canada sits under the gathering clouds so much better off than other nations. At the highest level, our employment growth over the past couple of years has been strong, incomes have been rising and our banks have shored up what were already strong positions with even more capital.

Stepping down a tier, more jobs and higher incomes in Canada have been leading to healthy housing demand with stable-to-rising home prices. These are necessary contributors to good consumer confidence.

Office vacancy rates in our major cities are much lower than across the border, absorptions rates are higher and government finances at all levels, while perhaps somewhat strained, are still in relatively better shape.  

Even on a political level, the outlook is for greater stability in Canada than in most other nations over at least the next four years. The Conservatives in Ottawa govern by means of a majority.

In many other “rich” nations, leadership comes in the form of minority rule or coalition government (Great Britain, Australia, and Germany). 

Alternatively, upcoming elections (Spain, Germany, France, and the United States) are rendering the positions of those in power more precarious.

Workers, especially in the public sector, are being told they must lower their expectations. This is leading to what might be termed Frankenstein politics. In protest, the villagers are taking to the streets with pitchforks and torches.

Additional calls for restraint have led to wide-spread strikes and labor uprisings in Greece, Portugal, Spain, the U.K. (where there was vicious rioting based on perceived socio-economic inequalities) and some States in America.

Compared to other nations, Canada is the place to be. This does not mean we won’t be rocked by the changing economic landscape. Most noticeably, the slowing world economy will take some of the oomph out of commodity prices.

An easing in raw material prices is expected to be mild, but it may still threaten the viability of some mega project investments.

The hope is that investors in those sectors – mining, energy and agriculture – are conscious of long-term time horizons and understand full well that demand from emerging nations can only go up, even if that means later rather than sooner.

Some other adjustment mechanisms are also important to keep in mind. Lower commodity prices mean reduced building costs.

Also, the shakier underpinnings of the world economy are signaling a retreat into the world’s reserve currency, the U.S. dollar. At least a temporary drop in the value of the Canadian dollar is underway.

This will be a welcome respite for Canadian manufacturers. It’s been a tough slog pitching sales into a less than ebullient U.S. market while further disadvantaged by a high-valued loonie.  


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