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Introduction: Welcome to Eyes on the Economy by CIBC Capital Markets, a podcast series dedicated to addressing current issues in a concise format, helping to make sense of the evolving economic complexities, so that you can take action.

Avery Shenfeld: Hello everyone and welcome to another edition of CIBC’s Eyes on the Economy podcast. Today we’re very lucky to be joined by a special guest, Lawrence Schembri, a former Deputy Governor of the Bank of Canada, as well as a very longtime staff member there, former professor at Carleton University, and going before that, PhD from MIT. And even longer, a little bit of a little known fact that Larry and I were both undergraduate students at University of Toronto in the same year. He went off to MIT. I made the smarter decision to go to Harvard, but we’ll leave that debate for later. Larry and I were struggling, I believe, if I recall correctly, in the same econometrics class. So it was interesting times, but it’s great to be back with Larry again. I’m Avery Shenfeld, the Chief Economist at CIBC. So, I think we should just get right underway here. And obviously, top of mind is just the general big question here. You know, what do you think of the state of the Canadian economy right now? I mean, we had a negative second quarter. The economy does seem to be growing again. Are we headed for a recession? Is it just a period of disappointment? How do you see it, Larry?

Lawrence Schembri: At the moment, I think the economy is in, what central bankers like to call excess supply. And you can tell that by looking at the unemployment rate. It’s increased to 7.1 percent in August from 6.6 percent in February. So the effects of the U.S. tariffs seem to be showing up. And also the uncertainty about future U.S. tariffs is also having a dampening effect. So there may not be a recession, but I don’t expect growth to be very strong, maybe 1 percent this year and a little bit stronger maybe next year. But I do think that the US trade policy situation really hangs over the Canadian economy and it’s creating a lot of uncertainty and I think that’s holding back a lot of investment in certain sectors, as you know, every year are hit hard in particular steel, aluminum, those sectors are greatly affected. I know that most of our trade with the United States still goes through tariff free because they comply with the USMCA, but the uncertainty around the USMCA, the future of it is really, I think, a critical issue. And, you know, it seems, in my view, unlikely that it’s going to be renewed in its current form. And we’re probably going to go to a bilateral agreement similar to what the US has with the UK or the Euro area, where there’s going to be a baseline tariff and some sectoral restrictions on what the US perceives as sensitive a sense of goods like steel, aluminum and so forth.

Avery Shenfeld: So certainly not the greatest picture as we look ahead, not at all. For a while, the Bank of Canada, as you know, was on hold in terms of interest rates. I mean, they cut interest rates aggressively last year, which with hindsight looks to be the right decision given what’s happened. They cut earlier in the year and then they held off for a while. And of course, part of their concern was that, well, they recognized that there was slack opening up, as you say, excess supply. They were still somewhat concerned about what was happening to inflation, what some of the underlying trends were there after stripping out things like the removal of the carbon tax and gasoline prices. But now there seems to be a bit of a debate at the Bank of Canada. Of course, they’ve resumed interest rate cuts, but also about how to measure that underlying inflation trend. And I know the bank is undergoing a process of rethinking or taking yet another look at what the right measure is or measures should be. Do you have a view on where you see underlying inflation, but also how the Bank of Canada should actually be measuring that?

Lawrence Schembri: Well, it’s an excellent question. I mean, I was around for the last time. We took a close look at the core inflation measures and I was a strong advocate of CPI common, which is a statistical technique to sort of identify the common trend amongst a large number of inflation components of the CPI basket. And I thought that the CPI common was really a useful indicator because it had the closest correlation with the underlying state of the economy that, typically when the economy is in excess supplies, it is now CPI common tended to move below 2% and when it was in excess demand, which has been from time to time, it went above 2%. So it seemed to be a good indicator of this general state of the economy. Now much of that fluctuation in economic activity was driven by what central bankers like to call demand shocks. And so it worked relatively well for most of the inflation targeting period until the pandemic. When the pandemic struck, it really lost its moorings and captured a lot of the correlation in the price shocks driven by supply disruptions, other imbalances that we saw globally. And so it really didn’t capture the underlying state of the economy very well because it’s just capturing all the common correlations in prices, which were really driven by factors outside the Canadian economy. So essentially, the Bank of Canada dropped that indicator as a measure of core inflation. And they’re now still using two other measures that we adopted at the time, CPI median and CPI

Avery Shenfeld: Trim.

Lawrence Schembri: Trim, yea, thank you. Jogged my memory. And those are currently indicating inflation close to 3%. I don’t think that’s really reflective of where we are in terms of the state of the economy. And it may be still capturing sort of lagged effects of wage catch up, cost of housing services and so forth. And so it’s not really capturing where we think the economy is given, that most estimates of the slack are somewhere between 1 and 2 percent. And the fact that unemployment is relatively elevated to where we think maybe a natural rate might be. So the Bank of Canada sort of expanded the set of indicators. In terms of looking at those that exclude food and energy, also exclude indirect taxes which have been affected by the removal of the carbon charge. So, you know, I think the bank’s estimate of underlying, estimate of like 2.5%, I think in the last NPR is roughly correct. But again, we don’t have a clear indicator like we once had about the underlying state of the economy, in particular the amount of slack. So, I think the goal with the bank is to try look more closely again at the data and see if they can come up with an indicator that sort of correlates with the amount of slack that we have in the economy or the excess demand we have in the economy. That may be a bridge too far, but it’s worth trying.

Avery Shenfeld: So the idea here is, in other words, to have something that’s not as sensitive to supply shocks and somehow more driven by whether demand is overheated or too cool.

Lawrence Schembri: Right, exactly, exactly. Exactly. And that may be in a world where supply shocks are dominant, that may be very difficult to identify.

Avery Shenfeld: Okay, so the bank has obviously decided that maybe inflation is not as high as some of its traditional core measures are saying. Obviously, you think it’s cool enough, given the slack, to start easing again. And the other debate that rages a little bit is, right now, we’ve got rates at 2.5. The bank’s sort of point estimate of neutral with a range around it is 275 with a 50 basis point range. Do you think that’s the right benchmark here? And should we be going now to a somewhat stimulative rate given the slack in the economy?

Lawrence Schembri: Again, a very good question. I think the range that the bank has had in place for their estimate of the neutral rate has remained relatively unchanged for the last five years, as far as I can recall. It’s between 2.25 and 3.25 percent. One might question whether that’s given the circumstances that we’re in globally, that’s still the valid estimate. I mean, typically it’s a very backward looking estimate and given the outlook for the global economy where most western industrialized countries, including the United States and ourselves, are going to run relatively big deficits driven in part by defense expenditures, but just ongoing needs for investment and so forth. So one can easily imagine in the future the neutral rate would be higher. And when I look at what’s going on in the United States. Chairman Powell said a few months ago that he considered 4.25 to 4.5 percent mildly contractionary, which seems to indicate that he has a much higher neutral rate in mind, roughly maybe 3.5 percent, which leads me to believe that one would think the neutral rate in Canada and the United States would be comparable, which leads me to think that maybe the estimate of neutral rate in Canada is a little bit too low. And so we may be already in stimulative territory when it comes to monetary policy.

Avery Shenfeld: Could the two rates be substantially different though across the two countries, just judging by the fact that if you look at this tightening cycle, for example, the one we just came through, as well as the one prior to the COVID recession, in both cases, the US seemed to tolerate much higher rates than Canada without seeing the same sort of slowing that Canada saw at somewhat lower rates. Does that sound like evidence that the neutral rate in Canada might be divergent and others lower than that of the US?

Lawrence Schembri: It could be. I think that’s a good argument in the sense that, you know, US economy still seems relatively robust. Unemployment rate is only 4.3%, which is slightly higher than it was at its lowest level of 3.7 and 3.8%. So there’s been much less of an increase. And so that’s an argument. But typically, given how integrated the financial markets are, one would think that the two rates should be comparable. I mean, that’s kind of the baseline assumption that we’ve always had that there may be slight differences, maybe 25 basis points or 50 basis points, but for the most part, they should be pretty close. But yeah, one could argue, given where we are now in terms of economic activity in the two countries, maybe there is a larger difference in the neutral rate.

Avery Shenfeld: Okay, so that actually leads to a nice segue to another topic I wanted to address briefly, which is US monetary policy. So the Bank of Canada, they put underlying inflation at two and a half. It’s a bit above their target, but not too far off. The Fed’s various estimates are more like 3%, but they’re also resuming interest rate cuts. Do you think that makes sense, what they’ve done now by cutting with inflation this far above their target? And as you point out, unemployment at 4.3, maybe it’s a bit above full employment, but not wildly above full employment.

Lawrence Schembri: I guess the issue for the Fed is they see the labor market slowing. When you look at the trend in the unemployment rate and various measures of labor market tightness, they do see a trend emerging that the labor market is opening up and so in terms of slack. And so, you know, I think there is a sense that they should try to get ahead of it in terms of the balance of risks have shifted towards more concerns about unemployment as opposed to inflation and that to some extent reflects their dual mandate. They have a dual mandate that focuses on slack in the labor market as well as the inflation rate being relative to its target. And so they may see the risk shifting, which I think is reasonable, although if one thinks that there’s going to be some pass-through of the US tariffs into domestic prices, one could argue as well that there’s some upside risk to inflation. It hasn’t happened yet. There hasn’t been a lot of broad-based inflation as a result of the tariffs, but it’s still early, and one can imagine that that could happen in the future. So when you look at the dot plot, there’s a few members of the FOMC that are calling for two or three cuts. I think it’s probably going to be one or maybe two, because I do think that the inflation could move up and so the risk could again tilt towards inflation as opposed to unemployment.

Avery Shenfeld: As a former central banker, I know you put a high value on central bank independence. That’s become a pretty big topic in the US now, at least some people quite concerned about the potential, basically, political takeover of the Fed. Are you worried about that? Do you see signs that that’s happening? And do you think that will end up impacting policy in a material way? Or do you see the Fed as likely to hold the line against that?

Lawrence Schembri: Well, the Fed is a very important institution in the United States, especially for its capital and financial markets. The credibility of the Fed is very important for the fact that U.S. Treasuries are the benchmark instrument that’s used. And so if expectations of inflation become unhinged because of threats to central bank independence, that’s a serious worry and I think that many lawmakers in the United States respect the independence of the Fed and would be loath to see changes put in place that would threaten that independence. I mean, I think that the administration can point members to the FOMC they think are favorable to their views, but I think at the end of the day, the mandate of the Fed is very clear. I mean, the mandate is 2% inflation and with an eye on maximum sustainable employment. If there was a push to change the mandate, I think that would be a serious concern. So I mean, I expect there’s going to be some pushback at the political level against really undermining the credibility and the independence of the Federal Reserve. I just think it’s too important an institution for the US economy.

Avery Shenfeld: Well, that’s certainly the view of virtually every card carrying economist as well. And it does seem to be, by the way, the view of the bond market because we don’t see the US dollar plunging and long rates soaring. So, you know, those would be signs, I think, that people are really worried about this. Just to conclude, I always like to give people who appear on our podcast a chance to sort of promote their own work. I know you’re at the Fraser Institute, affiliated with them. Are there things that you’ve written recently that you’d want to flag or ideas that you’re working on now that you want to draw attention to?

Lawrence Schembri: Well, I recently published a study that looks at the disappointing per capita growth experience Canada’s had over the period 2020 to 2024. That five year period was unusual in the sense that Canadian economy grew 1.5% per year over that period. But at the same time, GDP per capita fell like 0.5% each year over the period. So you had this strange combination where the overall economy was growing, yet a reasonable measure of the standard of living of the average Canadian was declining. And so we used a framework that the OEC had developed to really try to understand what was going on. And we identified two factors, one just weak overall business investment growth over the period, which reduced labor productivity. At the same time, you had a very large expansion in the labor force as a result of immigration, both current immigration as well as temporary foreign immigration. And so that also created the incentive for the weak investment in the sense that we note that capital price ratio declined. And so at the margin, firms that were looking to invest saw the opportunity to expand output instead of by investing by increasing employment. And so at that margin, the effect of the immigration was really pushed down that relative price. And that to some extent contribute to the weak investment growth. So that was one thing. And the other project I finished recently was looking at indigenous equity participation in major projects. And this is related to Bill C-5, that the government recently passed that would try to expedite major projects. And the reality is that many of those major projects would take place on traditional territory of indigenous communities. And so I argued for the fact that this, to have indigenous equity participation in those projects makes a lot of sense because that way you can obtain consent to those projects as well as generate income for them.

Avery Shenfeld: Well, certainly two very important sets of issues that the current government is actually to some extent acting on in the sense that we have slowed the immigration numbers, trying to reverse some of the temporary foreign workers, and as you know, also trying to get more indigenous participation to speed up some of these projects. So I guess we both wish them well in that endeavor, if that’s going to be part of the solution. So I’d encourage our listeners to, I assume that’s on the Fraser Institute’s website, if they want to follow up with that, I’d encourage them to do that.

Lawrence Schembri: That’s right. Both studies are there now.

Avery Shenfeld: And thanks to Larry for joining us. Thanks to our listeners for joining us for this issue of our podcast. Until next time, we’ll be keeping our eyes on the economy and calling it as we see it. Thanks very much for joining us.

Lawrence Schembri: Thanks, Avery. Thank you for your interest. It was a pleasure.

Outro: Please join us next time on the Eyes on the Economy where we will share our latest perspectives and outlook for the Canadian and US economy.

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Navigating uncertainty: Inflation, interest rates, and growth challenges in Canada

CIBC Economics

Avery Shenfeld

Managing Director and Chief Economist

CIBC Capital Markets

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