Wednesday, August 12, 2015

How many bullets does the Bank of Canada have left in its chamber?

It's been a while since I blogged about Canadian monetary policy, but Luke Kawa's recent tweet on the topic of Canada's effective lower bound got me thinking.

Luke is referring here to CIBC chief economist Avery Shenfeld's recent missive on how the Bank of Canada might react if the Canadian economy's losing streak were to continue. According to Shenfeld, the Bank of Canada has one final quarter point cut left in its quiver—from 0.5% to 0.25%. Should the bleeding continue, Governor Stephen Poloz can then turn to forward guidance and only when that has been exhausted will quantitative easing become a possibility.

Really? The Bank of Canada can't go below 0.25%? Has Shenfeld not been following what has been occurring outside Canada's borders over the last twelve months? Sweden's central bank, the Riksbank, has cut its repo rate to -0.35% while the European Central Bank has ratcheted its deposit rate down to -0.2%. The Swiss National Bank is targeting an overnight interest rate of -0.75%, down from 0% the prior year, at the same time that the Danmarks Nationalbank currently maintains a certificate of deposit rate of -0.75%. I've been covering this stuff pretty exhaustively here, here, here, here, and here.

After digging a bit further, I was surprised to find that the sort of interest rate emasculation implied in Shenfeld's piece is endemic here in Canada. David Rosenberg of Gluskin Sheff, for instance, recently said that Poloz has "just one bullet left in the chamber" while the FP's John Schmuel wonders what will happen if the Bank of Canada is forced to use its "last remaining lifeline and cut its rate to zero." The Bank of Canada is also a transgressor in spreading the meme: on its FAQ, the Bank says that the overnight rate's lowest possible level—its effective lower bound—is 0.25%.

One reason the faux 0.25% lower bound continues to circulate in the public discourse is the somewhat lazy reliance commentators have on the Bank of Canada's credit crisis playbook as a model for how low rates can go. In addition to implementing forward guidance during the crisis, the Bank reduced the overnight rate to 0.25% by flooding the system with excess balances. But this playbook has gone stale. As I've already pointed out, a number of European central banks have demonstrated the possibility of going below zero. A Bank of Canada deposit rate cut to as deep as, say, -0.50%, combined with an overnight target of -0.25, effectively buys Poloz three more 25 basis point interest rate cuts, not just one.

Ask folks why Canadian markets can't bear negative interest rates and there's typically a lot of arm-waving and mumbling about money markets. Case in point is Shenfeld on the +0.25% level: "In the Canadian money market structure that’s as low as she gets, and effectively represents the zero lower bound for monetary policy." I'm not aware of a single Canadian fixed income product that can't bear slightly negative interest rates. Would maple syrup commercial paper markets come to a standstill if the Bank of Canada cut rates to -0.25%? Would the market for Gordie Howe bonds collapse? While no doubt a nuisance, the transition to negative rates has been managed by money markets in Denmark, Sweden, Switzerland, and the rest of Europe without major mishap. There's simply no justification for Canadian exceptionalism.

While slightly negative rates won't cause structural problems in money markets, deeply negative rates would certainly be problematic. Send rates low enough and bank runs will begin as people cash in their negative-yielding money market instruments for paper dollars. At some point the banking system would cease to exist. But this doesn't occur at Shenfeld's so-called 0.25% lower bound, nor at -0.75%. Thanks to the carrying costs of bulky banknotes, it probably only starts to be a problem somewhere between -1.0% to -3.0%. The existence of a wide safe zone before hitting those levels gives the Bank of Canada a lot more lifelines than just one.

The last reason for the circulation of a false lower bound in Canadian monetary policy discussion is vested interests. I doubt that Canada's big banks are fond of incurring the frictional costs associated with transitioning to a negative rate world. Better to "wipe out" that possibility from the Overton Window and push something less-threatening like forward guidance.

Let me be clear that I have no specific insight into whether the Bank of Canada should be loosening or not. What is important is that the Bank has flexibility to the downside should it decide that easing be necessary. Breathing space is important because pound-for-pound, actual interest rate cuts are always better than unconventional policies like forward guidance—the promise to keep interest rates too low in the future—or quantitative easing. A move to -0.15% or -0.25%, should it be necessary, represents a continuation of the Bank of Canada's decades' long method of implementing conventional monetary policy via direct interest rate adjustments. It's not fancy, but it has been in place for a long time and everyone pretty much gets it by now. Central bank guidance, on the other hand, is complicated and suffers from the fact that the public can never be sure that a three-year promise initiated by a Conservative-appointed governor will stay in place should an NDP-appointed governor take his place. As for quantitative easing, it doesn't even work in theory, as pointed out by none other than Ben Bernanke. (Or see how New Zealand's cashing up the system had no influence on prices)

Incidentally, if Canada were to suffer a broader shock than the current one and the Bank of Canada found it necessary to go deep into negative territory, say -6%, there are all sorts of ways it can go about doing so without causing stress in money markets. In fact, economist & blogger Miles Kimball recently visited the Bank of Canada to explain how to go about implementing extremely low rates without igniting a run into paper dollars, or what he refers to as massive paper storage. I've written about some "lite" ways to go about doing so as well.

Interestingly, Kimball writes that the Bank of Canada already has an “Effective Lower Bound” working group that is focused on "exploring the possibilities for negative interest rate policy in the next recession." So while the public discourse on Canadian monetary policy seems to have settled on the "one remaining lifeline" view, it appears that internally that is not the case—the Bank of Canada knows that it has much more up its sleeve.

Various charts:


  1. "Ask folks why Canadian markets can't bear negative interest rates and there's typically a lot of arm-waving and mumbling about money markets."

    Wipes hands on oily rag, shakes head and mutters stream of unintelligible technical gibberish in fake Scottish accent, ending with: "The engines canna' take it Captain Poloz!"

    One theory floating round in 2008 (I never knew if it was intended seriously) was that the Bank's computers would explode if they tried to divide by 0%. But we economists never did understand it, as far as I knew. It was something too technical and institutional for us.

    1. "...that the Bank's computers would explode if they tried to divide by 0%"

      Sounds fishy.

      I know this popped up when Germany went sub-zero. It seemed to be a non-event.

    2. Why are the interest rates important? Zero just means that the CB can expand the monetary base to infinity without shifting rates. Keep buying assets, don't worry about zero. To infinity and beyond!

    3. My thoughts on the "keep buying assets to infinity" meme are in the link above about New Zealand "cashing up the system" and also here:

    4. JP, it's more than a meme. Control over the monetary base is the CBs biggest sole power.

      Re Google, there is no connection between a modern central banks assets and liabilities. There is no deliverable, full stop, zero argument. Re New Zealand, there is a difference between reserves and currency. Looking at reserve production and saying "look, no NGDP" is foolish. Reserves have no nexus with NGDP. In fact, just looking at reserves as a CB liability passes over how they are a bank asset - and bank assets are set against liabilities - I.e. Debt. It is entirely conceivable that an overleveraged banking system absorbs an immense volume of reserves with little effect on NGDP.

      A highly leveraged economy simply implies that buying assets until infinity takes longer than you, JP, might imagine. CBs control the numeraire, full stop.

  2. I did a reverse image search on your illustration. "Russian Roulette" is what came up.

    A year ago I read a prediction about Canada by the end of 2015. I'll be interesting to see how that works out.

    1. Reverse image search?

      Bar any large shocks, it looks like Canada will probably undershoot headline inflation by the end of 2015, but not core inflation.

    2. Hi JP, here's the reverse image search results.

      Regarding the prediction, it came from a model. Are you aware of other models predicting (in July of 2014 or earlier) an inflation undershoot in Canada by the end of 2015? That's be interesting. Thanks.

  3. My first reaction is that the best banking system in the world warrants a higher hurdle for mucking about with negative rates.

    How effective have the European experiments been? That's important to know. Have they been successful? How do we know that?

    1. "How effective have the European experiments been?"

      There were some hassles, but money markets in Europe have managed to cope with negative rates.

      If Canada has the best bankers, shouldn't they more than any other nation's bankers be able to cope with the challenge of negative rates?

  4. Fiscal policy is the best counter-stabilisation tool available to any government

    "The reality is that policy makers have very little idea of the speed and magnitude of monetary policy impacts (interest rate changes) on aggregate demand. There are complex timing lags given how indirect the policy instrument is in relation to its capacity to influence final spending.

    Further there are unclear distributional effects – creditors gain when rates rise, debtors lose. What will be the net effect? Central bankers do not know the answer to that question.

    Monetary policy is also a blunt policy instrument that has no capacity to target specific segments of the spending population or regions.

    Fiscal policy expansion is always indicated when there is a spending gap. It is a direct policy tool ($s enter the economy immediately) and can be calibrated and targetted with more certain time lags. Liquidity trap or not, fiscal policy is the best counter-stabilisation tool available to any government."


    Modern Monetary Theory in Canada

    1. Larry, fiscal policy is part of the political beast and will therefore be (for lack of a better word) stupid. Monetary policy is technocratic and therefore far more likely to be wielded intelligently. Were central bankers democratically elected and Prime Ministers/Presidents technocractically appointed, then fiscal policy would be wielded intelligently while monetary policy would be stupid. Until then, the best counter-stabilization tool is monetary policy.

    2. Central banks are run by people, and those people are just as corrupt, just as embedded in class viewpoints, and just as political as all the other politicians. Those feting central bankers as latter day Solomons really need to rethink their position. All individuals suffer from the same human failings. Democracy is how we mediate those failings.

  5. Very O/T--a real-life update on human capital contracts, which we discussed a while ago:

    From The Economist:

    "Under Mr Rubio’s plan, private investors would pay for a student’s education in return for a claim on a chunk of his future earnings (see article). Just as dividends accruing to a shareholder depend on a firm’s profits, so a student’s subsequent payments to the investor would rise and fall with his income. Equity financing would lead to more informed choices because investors would be less willing to fund courses and colleges that offer low returns. And it would squeeze costs because unpopular courses would have to trim their spending."

    I hope the idea gets more attention as an alternative to Clinton's student loan forgiveness plan. I doubt Rubio himself has a shot to win, though--I expect Trump to shoot up in the polls soon.