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Inside the Bank of Canada’s Toolkit

While the U.S. Federal Reserve is poised to hike interest rates at next week’s meeting, it’s worth remembering that most of the world’s major central banks are currently in easing mode.

Aside from fending off the specter of disinflation or outright deflation, perhaps these policymakers see something on the horizon that their U.S. peers don’t.

The Bank of Canada (BoC), which had been one of the developed world’s more hawkish banks following the downturn, is one of them.

After holding its benchmark overnight rate at 1.0% for just over four years, the longest pause in about 60 years, the central bank has cut rates by a quarter-point twice this year, bringing its overnight rate to 0.50%.

At current levels, short-term rates are just a quarter-point above the record low in 2009, at the height of the Global Financial Crisis.

Of course, there’s a very good reason for such accommodative monetary policy. The BoC is trying to provide a sufficient cushion to offset the shock from the collapse in commodities prices.

Although the energy sector accounts for about 10% of Canadian gross domestic product (GDP), that figure doesn’t fully capture how the sector’s growth flowed throughout the country’s economy. For instance, prior to crude oil’s crash, energy sector spending accounted for about one-third of the country’s total business investment.

Central bank chief Stephen Poloz expects the Canadian economy to continue rebounding and finally reach full capacity by mid-2017, but he’s also prepared for the risk of another unforeseen shock that could rock the country’s economy. Despite his overall optimism, Poloz acknowledged, “ … we’re paid to worry, and to be prepared.”

But for those in the secular stagnation camp, Poloz disagrees. Instead, he sees weak global growth as cyclical rather than secular, though he concedes that “the cycle is proving to be longer than usual.”

Borrowing from famed economist John Maynard Keynes, Poloz believes that the global economy suffers from a lack of “animal spirits,” the sort of confidence that inspires risk-taking entrepreneurs to drive new growth.

So what might the BoC do in the event of another economic shock? In a speech before the Empire Club of Canada this week, Poloz described the four tools in the bank’s unconventional monetary policy toolkit: forward guidance, large-scale asset purchases, funding for credit, and negative interest rates.

Forward guidance is essentially a form of public relations. The bank signals its stance on monetary policy for a specific period in order to remove uncertainty. That helps keep a lid on long-term rates, while giving key economic players the confidence to invest in new growth.

Although the BoC has never made large-scale asset purchases, its U.S. counterpart has extensive experience with what is otherwise known as quantitative easing. In the wake of the downturn, the Fed undertook three successive rounds of quantitative easing, buying vast quantities of long-term bonds in order to keep key rates down.

Funding for credit is a tool that ensures crucial sectors of the economy still have access to capital in the event of a lending freeze. Here, too, the BoC has never implemented such a measure, but fellow countrymen at the Canada Mortgage and Housing Corporation, which bought insured mortgages from lenders during the downturn, could provide a few tips.

But the measure that’s garnered the most headlines by far is what Poloz had to say about negative interest rates. During the crisis, the BoC put a line in the sand at the 0.25% level for its overnight rate.

At the time, the bank’s policymakers were concerned about how various money markets might adapt to rates at zero or below. Since then, they’ve seen peers at other institutions, such as the European Central Bank, implement such measures and watched the markets adjust accordingly. Consequently, the new line in the sand is -0.50%.

Though it does strike us as odd timing for a customarily cautious central banker to explain in depth how he might respond to yet another economic shock—commodities prices have slumped even further in recent weeks—we’ll chalk it up to navel-gazing wonkishness.

Others in the financial media, however, were quick to pronounce doom. But that would be at odds with the bank’s own forecasts, which project GDP to grow by 2.0% next year and a further 2.5% in 2017.


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