Bank of Canada Just Announced QE and Zero Interest Rate Policies
By JC Collins
Things just went from bad to worse for Canada. Along with a continuing collapse in crude prices, and a teetering real estate market, the Federal Reserve in the United States is set to increase interest rates on December 16th for the first time in ten years.
Traditionally the Bank of Canada would match interest rate increases in the US with its own increases. The challenges which Canada faces by increasing interest rates is that the country holds the title for the highest level of private debt in the world, as well as one of the most overvalued real estate markets.
Any rate increases by the Bank of Canada will send debt management costs into the stratosphere, causing a collapse in real estate markets over an extended period of time.
As such, Canada is faced with two choices. One, match the rate increases in the US and suffer the economic fallout. Two, don’t match the rate increases. The latter of the two choices will cause the Canadian dollar to depreciate even further against the US dollar. Neither choice is great.
It appears we may have been given an answer on what direction Canada will go. A policy paper titled Framework for Conducting Monetary Policy at Low Interest Rates was published today by the Bank of Canada. It outlines the macroeconomic policies which the Canadian central bank will have to embark upon in an environment of low interest rates. This is a clear signal that the Bank of Canada intends on not matching the interest rate increases by the Federal Reserve.
The effects of this will mean a huge decrease in the exchange rate between the looney and the dollar. So even though debt management will not increase in the interim, the cost of imports for Canadians are set to increase dramatically.
Add this to continued losses on the Toronto Stock Exchange, a bleeding of wealth and foreign investment, and Canada is set for a downturn which will be equal too, or greater than, the turmoil which rocked the United Stated in 2008 and 2009.
Such a downturn will put increased pressure on the real estate markets and credit markets, regardless of what the Bank of Canada does with interest rates.
Below are the policy snapshots from the Bank of Canada publication. All Canadians should be seriously concerned. Especially when our federal government is already re-adjusting their budget deficit numbers. – JC
Help support POM and further research by subscribing. Members will receive more detailed analysis on macroeconomic trends and esoteric reflections on the human experience.
The Bank has at its disposal a suite of extraordinary policy measures that could be used to provide additional monetary stimulus at very low interest rates. International experience has demonstrated that these measures can be effective in helping a central bank achieve its objectives. In each case, the measure can provide additional monetary stimulus and/or improve credit market conditions.
Without prejudging the order or efficacy of their use, the available measures are as follows.
In contrast to the more typical interest rate environment, there are clear benefits in a very low rate environment associated with conditional statements about the path of policy that are tied to the inflation outlook or other economic variables. In particular, statements that provide extraordinary forward guidance allow a central bank to provide additional monetary stimulus by influencing the expected duration of low interest rates and/or providing greater certainty regarding the interest rate outlook. The Bank could also back up these statements with offers of longer-term purchase and resale agreements (PRAs) at rates consistent with its guidance regarding the operating band.
Credible forward guidance by a central bank to keep short-term rates low for a longer period than expected by the market should lower bond yields throughout the term structure and, in turn, support the prices of other financial assets and the depreciation of the currency— all of which serve to boost aggregate demand, leading to an increase in output and inflation.
Negative policy rates
In principle, nominal interest rates cannot fall below zero because investors can always earn a zero nominal return by holding currency. In practice, however, the nominal return for holding currency is negative, due to storage, transportation, insurance and other costs associated with securing and storing bank notes, particularly in large quantities. These costs make it possible for nominal interest rates to fall somewhat below zero.
In April 2009, the Bank set an effective lower bound (ELB) of 25 basis points for the overnight rate. The choice of a slightly positive ELB was motivated in part by concerns about the need to provide lenders and borrowers with the incentive to transact in markets. At the time, there was substantial uncertainty about the impact of very low interest rates on market functioning. This uncertainty led most central banks to exercise due caution by setting a slightly positive ELB.
Recent international experience has led to a reduction in this uncertainty. Several countries have adopted negative policy rates, and, in these jurisdictions, markets have continued to function effectively. The Bank’s analysis suggests that Canadian markets would also continue to function effectively in an environment with a policy rate below zero. At this time, the Bank’s best estimate is that the ELB for the target for the overnight rate is approximately -0.5 per cent.
Considerable uncertainty remains, however, as to precisely how far below zero the policy rate could go before markets became materially impaired or the demand for bank notes increased significantly. Furthermore, the Bank’s estimate will likely evolve over time as we monitor the experiences of other central banks operating in a negative interest rate environment or observe how Canada’s financial system would adapt to a negative rate environment. In practice, should rates be lowered below zero, the risk of triggering unintended consequences would need to be assessed carefully, based on a detailed and continuous monitoring of indicators of market functioning and the demand for bank notes. In the event that the Bank judged that the lower bound was being approached, it would clearly communicate that information to the public.
Large-scale asset purchases
Outright purchases of financial assets through the creation of excess settlement balances (that is, central bank reserves) will push up the price of, and reduce the yield on, the purchased assets (which could include longer-term government securities or private assets such as mortgage-backed securities and corporate debt).2 The expansion of settlement balances would encourage the acquisition of other types of assets (portfolio rebalancing), reducing yields more generally and easing overall financial conditions. As with conventional monetary policy easing, the exchange rate would typically depreciate in response to lower interest rates.
Funding for credit
In some circumstances, the supply of credit to particular sectors of the economy may become impaired. To ensure that credit market impairments do not restrain aggregate demand, funding for credit facilities could be established. Facilities of this type would provide collateralized term funding to banks at a subsidized rate. In return, banks would need to meet certain lending objectives in order to qualify for access to the facility. A key advantage of this type of facility is that it would enable the Bank to target the measure to those specific sector(s) of the economy where credit supply is judged to be impaired.
Sequencing of the policy measures
There is no predetermined bias regarding the order in which the policy measures identified above are used. The efficacy of each measure would depend on the economic and financial context. For example, there may be more scope for forward guidance to reduce the expected path of the policy rate when markets expect the policy rate to rise faster than warranted by economic conditions, including the outlook for inflation. In another situation, a funding for-credit program may be more effective when credit market impairments are an important restraint on aggregate demand.
In some cases, the measures could be complementary. While international evidence has shown each of these measures to be effective, there are likely to be limits on the degree of stimulus that can be provided with any single measure. However, given that each measure operates through somewhat different channels, the measures can be used in conjunction for greater effect and, in many cases, would be mutually reinforcing. For example, asset purchases could be used to reinforce a conditional commitment made through forward guidance. Given the uncertainty concerning the magnitude of the impact of each policy, using several measures simultaneously would help to diversify the risks associated with under- or overestimating such impact.