Bank of Canada governor Tiff Macklem and United States Federal Reserve chair nominee Kevin Warsh are misinterpreting the effect of productivity on the economy and what it could mean for interest rates, according to a Desjardins Group economist.
Royce Mendes, managing director and head of macro strategy at Desjardins Group, said that both policymakers tie only one variable—the potential of the economy—to where interest rates should be set. This misinterpretation is leading them to potentially make mistaken estimates of the neutral rate and, consequently, decisions around interest rates.
Canada's neutral rate, which is calibrated to neither stimulate nor depress economic growth, currently ranges from 2.25 per cent to 3.25 per cent. The Bank of Canada is set to release its annual estimate of the neutral rate alongside its latest interest rate decision on Wednesday.
Warsh's View on AI and Productivity
Kevin Warsh, during a U.S. Senate confirmation hearing last week, stated that an artificial-intelligence-led productivity boom will not lead to higher inflation, thereby leaving room to cut the Fed's benchmark interest rate. However, Mendes countered in a note on April 22 that economic theory has established that productivity increases when capital spending rises, pulling along consumers who end up saving less. Increased spending spurs demand, and inflation typically follows.
Macklem's Stance on Lower Productivity
Tiff Macklem, during a speech earlier this year, said that lower productivity leads to weak growth, so cutting interest rates can risk “stoking future inflation” and delaying “needed structural change.” But Mendes argued that a lower productivity scenario or a lower potential output scenario are not sufficient reasons to expect lower interest rates to stoke inflation.
He emphasized that the problem regarding rate setting is which version of the neutral rate is being used—at least in today's environment. The benchmark lending rate is currently 2.25 per cent, and policymakers have made a few references to their belief that rates are in stimulative territory.
Short-Run vs. Long-Run Neutral Rate
Mendes is not expecting any changes to the central bank's neutral rate policy on Wednesday, but he said it should implement a different regimen to determine what is the appropriate neutral rate as well as what is stimulative and what is not. “What they forecast is a very, very long-term concept of neutral, which is almost useless for calibrating where policy should be today because there are two ways to measure neutral: a short-run neutral and a long-run neutral,” he said.
Because policymakers take a long-term view of neutral, they “look through” seismic economic events such as the tariff war with the U.S. and its effects on business investments and productivity, as well as a contraction in population growth. “If you look at those two big factors, population growth and productivity growth, both of them are extremely weak in the current environment, and both would suggest that the short-term neutral rate is below whatever the estimate of the long-term neutral rate is,” Mendes added, noting that a lower neutral rate could lead to lower interest rates.
