Sunday, December 7, 2014

On vacation since 2010

On a recent trip to Ottawa, I stopped by the Bank of Canada. The door was locked and the building empty. Odd, I thought, why would the Bank be closed in the middle of a business day? A security guard strolled up to me and told me that the entire staff packed up back in 2010 and left the country. He hadn't seen them since. Bemused I walked back to my hotel wondering how it was that with no one guiding monetary policy, the loonie hadn't run into either hyperinflation or a deflationary spiral.

Exactly 175 months passed between February 1996, when the Bank of Canada began to target the overnight rate, and September 2010, the date of the Bank's last rate change. Some 63 of those months bore witness to an interest rate change by the Bank, or 36% of all months, so that on average, the Governor dutifully flipped the interest rate switch up or down about four times a year. Those were busy years.

Since September 2010 the Governor's steady four-switches-a-year pace has come to a dead halt. Interest rates have stayed locked at 1% for 51 straight months, more than four years, with nary a deviation. I enclose proof in the form of a chart below. Not only has the Bank of Canada been silent on rates, it hasn't engaged in any of the other flashy central bank maneuvers like quantitative easing or forward guidance. In the history of central banking, has any bank issuing fiat money (ie. not operating under a peg) been inactive for so long?

Worthwhile Canadian chart: The Bank of Canada overnight rate target

Now the Bank of Canada will of course insist that you not worry about the lack of activity, its staff is still toiling away every day formulating monetary policy. But maybe the security guard was right. How do we know they haven't all been on an extended four-year vacation, hanging out in Hawaii or Florida? Who could blame them? Ottawa is awfully cold in the winter! With no one left at the Bank to flip the interest rate switch, that's why it remains frozen in time at 1%.

In theory, the result should be disastrous. With no one manning the interest rate lever, the price level should have either accelerated up into hyperinflation or downwards into a deflationary spiral. Why these two extreme results?

Economists speak of a "natural rate of interest". Think of it as the economy-wide rate of return on generic capital. The governor's job is to keep the Bank's interest rate, or the rate-of-return on central bank liabilities, even with the rate-of-return on capital. If the rate of return on central bank liabilities is kept too far below the rate on capital, everyone will want to sell the former and buy the latter. Prices of capital will have to rise ie. the purchasing power of money will fall. This rise will not close the rate-of-return differential between central bank money and capital. With the incentives to shift from money to capital perpetually remaining in effect, hyperinflation will be the result. Things work in reverse when the governor keeps the rate-of-return on central bank liabilities above the rate-of-return on capital. Everyone will try to sell low-yielding capital in order to own high-yielding money, the economy descending into crippling deflation.

In theory, there is no natural escape from these processes. The Bank needs to intervene and throw the interest rate lever hard in the opposite direction in order to pull the price level out of its hyperinflationary ascent or deflationary descent.

By the way, if this is all a bit boring, you can get a good feel for things by playing the San Francisco Fed's So you want to be in charge of monetary policy... game for a while. When you play, try keeping the interest rate unchanged through the course a game—you'll set off either a deflationary spiral or hyperinflation. Be careful, this game can get a bit addicting.

The upshot of all this is that with the Bank of Canada policy team on holiday and the policy rate stuck at 1%, any rise (or fall) in the Canadian natural interest rate is not being offset by an appropriate shift in the policy rate. Prices should be trending sharply either higher or lower.

However, a glance at core CPI shows that Canadian inflation has been relatively benign. Canada has somehow muddled through four years with no one behind the monetary rudder. How unlikely is that? Imagine Han Solo falling asleep just prior to entering an asteroid field only to wake up eight hours later to discover he'd somehow brought the ship through unscathed. We already know that the possibility of successfully navigating an asteroid field is approximately three thousand seven hundred and twenty to one—and that's with Han awake. If he's asleep, the odds are even lower. By pure fluke, each asteroid's trajectory would have to avoid a sleeping Han Solo's flight path in order for the Millennium Falcon to get through.

Success seems just as unlikely for the Bank of Canada. For us to have gotten this far with no one behind the wheel, the return on capital must not have changed at all over the last four years, the flat 1% interest rate thus being the appropriate policy. Either that or the return on capital zigged only to zag by the precise amount necessary to cancel out the zig's effect on the price level. However, I find it unlikely that the economy's natural rate of interest would stay unchanged for so long, or that its zig zagging was so fortuitous as to preclude a change in rates.

Alternatively, it could be that Canadians assume that the Bank is being vigilant despite the fact that the entire staff has skipped town. Even if a difference between the rate of return on capital and a rate of return on money arises thanks to normal fluctuations in natural rate of interest, Canadians might not take the obvious trade (buy higher yielding capital, sell low-yield money) because they think that the Bank will react, as it usually does, in the next period by increasing the rate of return on money. And with no one taking the trade, inflation never occurs. But is it safe to assume that people are willing to leave that much money on the table?

Another possibility is that the traditional way of thinking about monetary policy needs updating. I considered this possibility here. In short, when the return on Bank of Canada liabilities lags the return on capital, rather than a perpetual acceleration developing the price level stabilizes after a quick jump. This sort of effect could arise from central bank liabilities having some sort of fundamental value. Once the purchasing power of these liabilities falls low enough, their fundamental value kicks in, closing the rate-of-return differential between capital and money and preventing a hyperinflation from developing. So even with no one manning the Bank of Canada interest rate lever, the fundamental value of Bank of Canada liabilities provides an anchor of sorts, explaining why prices have been stable over the last few years.

I may as well come clean about the Bank of Canada. They haven't all gone to Hawaii. The real reason its HQ on Wellington Street was shut the day I visited is that it's being renovated. Rest assured the whole crew is hard at work at a temporary spot elsewhere. But does it make a difference? The monetary policy staff may just as well have gone to Hawaii in 2010. With the interest rate lever neglected and rates frozen at 1%, the evidence shows that prices would not have been sent off the rails, despite the fact that returns on capital surely jumped around quite a bit. It's all a bit odd to me.


  1. Don't you think the reason it has stayed the same for so long is that the bank of Canada just follows US central bank rates?

    1. The point isn't why it has stayed the same for so long. The point is: why hasn't this non-action caused either hyperinflation or a deflationary spiral? Go play the San Francisco Fed game.

  2. Great mind-bending post, though it does add to my discouragement that I'll ever be able to make heads or tails of the behavior of central bank money (or the significance of the "natural rate"). I'm glad I only follow this stuff as a hobby, not for a living.

    In theory, the result should be disastrous....However, a glance at core CPI shows that Canadian inflation has been relatively benign.

    Just curious: do you think monetary policy has anything to do with the (possibly) overvalued Canadian housing market? Is this even a concern?

    P.S. The Fed game is a fun little time-waster. Pity there don't seem to be many good economics or business computer games (I've looked, and it's slim pickings). Simulations could be great learning tools.

    1. Monetary policy may take the housing market into account. However, in Canada we have a housing agency called the Canadian Mortgage and Housing Corporation, which insures mortgages. If the government thinks they need to worry about housing prices, they can use the CMHC to implement policy so that the BoC can focus entirely on CPI.

    2. Good info, thanks. The housing thing pops up every few months in the Economist, but I don't recall seeing mentions of the CMHC specifically. I guess it falls under the macroprudential umbrella.

  3. I think you're defining monetary policy too narrowly. And I don't think the way out is to consider a price jump into a new equilibrium, as in the alternative post you linked.

    Monetary policy is not merely the rate on CB liabilities relative to the "natural rate." It is also the expected future rate on CB liabilities relative to, (or rather contingent upon) the future natural rate. That is, not just *the* expected future rates, but the entire distribution of expected future rates contingent on various economic conditions. And like in IBM, the weighted sum of all hypothetical futures is much more important than the going rate at any point in time. If the CB had come out in the middle of 2012 and said "we are not changing the interest rate right now, but we're planning on raising it to 12% on a cold Tuesday in 2018 irrespective of economic conditions," would you still say monetary policy was on vacation?

    From this perspective, it is hardly a huge coincidence that it has been able to maintain the same current short rate since 2012, and it doesn't require serendipitous zig-zagging of the natural rate. The current rate simply isn't very important. Note that the 10YR did plenty of dancing during that period, ranging from 1.6 to 3.7%, and this was not all term premium. But even that is too narrow, because the vast, unobserved contingent real rate curve may have moved around even more.

    It's open for debate how severely the BoC has changed its entire reaction function over those four years while keeping the short rate in place, but it has many other ways of doing so besides raising or lowering rates such as their communications and monetary policy reports (but also things like rumor and omission). The actual short rate just isn't very important, and isn't a good indicator of either monetary policy or the passivity of a CB.

    1. Good answer. I wrote about future rates a while back, forgot all about it.

  4. JP –

    OT: Thoughts on the Cochrane paper…

    (I imagine that, unlike me, you probably understand the fiscal theory of the price level...)