Too Much of a Good Thing? With Canadian inflation well contained for the time being, and economic growth very sluggish, there's no reason for the Bank of Canada to be shy about cutting interest rates in the week ahead. Indeed, if 25 basis points would be helpful, 50 bps would be even better, considering that the spread between the Bank's overnight target and the more relevant three-month private sector rates remains wide. Look for a half-point cut, with a statement that doesn't rule out further moves ahead. But in the US, talk from an eminent economist, Harvard's Martin S. Feldstein, is that additional cuts from the Fed would be too much of a good thing. Indeed, futures markets have also been moving their forecast that way, pricing in a much smaller further easing cycle even as economic data deteriorated in recent weeks. Feldstein's view, which we don't share, is that more rate cuts would be both ineffective in stimulating demand and inflationary at the same time. How can those both be true? On the demand side, he argues that interest sensitive residential construction spending isn't going to be amenable to stimulus given excess supply. But the same could have been said for every rate cut since 5.25%. Lower rates will help some shaky floating rate borrowers avoid default, and help others buy up foreclosed homes, important steps towards eventually putting a floor under home prices and housing starts. In a more plausible critique, he notes that mortgage rates didn't come down after the last 75-bp move, so why do more? If lower overnight rates built inflation fears that pushed up longer rates, it might be time to stop. But that might not be what happened here. The Fed not only cut 75 bps, but also had two votes against the move. The resulting doubts about further rate cuts pushed up the fed funds futures yields, stalling further progress on fixed mortgage rates. The TIPS-Treasury spread measure of inflation expectations shows no real alarm. Maybe the Fed just needs to make clear that more cuts are coming. The good professor also argues that while not stimulating demand, lower rates are pushing up prices for food and energy, leading to a drag on global growth. His reasoning is that rate cuts lower the opportunity cost of holding long positions in commodities futures or storing commodities as an investment. A beautiful theory; academic economists are good at the theory. But long speculative positions in oil futures have not been rising in the past year, and both oil and grain inventories are notably lean. Someone seems to be putting the products into their gas tanks and mouths, maybe not in the US, but perhaps overseas. It's demand, not speculators responding to low rates, pushing up both food and energy costs. Further rate cuts from the Fed may not help, but they couldn't hurt. With some hawkish voices on the Fed, we may not reach our 1.25% target. But Ben S. isn't likely to take Martin S.'s advice to go cold turkey on rate cuts as job losses mount in the second quarter. Avery Shenfeld Senior Economist
