The Bank of Canada Playbook – Part 1

Given the extraordinary unconventional monetary policies enacted by central banks since the Great Financial Crisis of 2008, there has been no lack of speculation and suspicion regarding the Bank of Canada’s likely response to a future financial crisis triggered by a collapse of the Canadian residential real estate market. The BoC’s actions during the crisis, however, provides an incomplete framework of likely policy responses to future large-scale financial contagions since the dislocations within the financial system were not as acutely felt in Canada in 2008-2009 as they were in many other developed economies at the peak of the crisis.

As a consequence, with the exception of the short-term emergency liquidity provisions provided at the time of the financial panic, relatively few unconventional monetary policy tools were in fact utilized by the BoC in 2008 relative to other central banks. This has left us with a relatively minimal “uniquely-Canadian” historical framework to draw upon when attempting to predict the BoC’s playbook for future financial crises within Canada. Fortunately, since the financial crisis of 2008 the BoC has on many occasions referenced (through various papers, studies, and speeches) the relatively expansive toolkit of unconventional monetary policies they would likely consider in the event of a full blown financial panic.

While some of these articulated policies are drawn from the BoC’s analysis of the effectiveness of its own policies during 2008-2009, others are based on how extraordinary monetary policies fared in other countries and the likelihood and feasibility of their implementation within a Canadian framework. Part 1 of this series examines the suite of monetary policies likely to be undertaken by the BoC in response to an even larger-scale financial crisis than that of 2008-2009, focusing on unconventional monetary policy from the perspective of the BoC’s manipulation of its key overnight interest rate, both in real and nominal terms. The analysis is largely guided by the historical context of past BoC actions both during and after the Great Financial Crisis, as well as BoC guidance on unconventional monetary policy from 2008 to present date.

Low-Hanging Monetary Policy Tools: A 2008 Redux

The BoC’s response to the financial crisis of 2008-2009 is particularly instructive with respect to future unconventional monetary policy because of the BoC’s well-defined principle of “graduated interventionism”. In other words, the BoC follows a framework that monetary policy must be commensurate to the severity of the problem and be escalated only gradually as required. While no two financial panics are ever exactly the same, the BoC’s actions during the Great Financial Crisis can generally be considered as a first-step policy response to any future financial crisis stemming from a collapse of the residential real estate market in Canada.

As many people are no doubt aware, the preferred monetary policy tool among central bankers and the one first turned to by the BoC during the 2008 financial crisis was to immediately begin lowering its key overnight rate in an attempt to stimulate Canadian economic growth. By successively slashing the overnight rate from 4.5% to its “Effective Lower Bound” (ELB) of 0.25%, the BoC served to dramatically reduce the interest rates that banks charge borrowers for loans, effectively increasing both spending and investment and thus raising what modern-day economists often refer to as “aggregate demand”.

While the ELB was kept slightly positive due to the uncertainty among central bankers of the full impact of zero-percent interest rates on the Canadian financial system, for all intents and purposes the BoC had effectively undertaken a zero interest rate policy by April 2009. The BoC’s interest rate had essentially reached the much-discussed “zero-bound”, which is widely believed by policy-makers and economists to be the point where further cuts to the Bank’s key overnight rate are rendered largely ineffective.

According to this reasoning, subsequent reductions of the BoC’s target overnight rate to below zero effectively turns interest rates negative and serves to penalize bank depositors by reducing the value of their savings and checking balances over time. Under these conditions, the general population prefers to hold zero-yielding physical cash rather than be penalized for either holding deposits or lending money within the banking system, a phenomenon mainstream economists refer to as a “liquidity trap” which imposes a theoretical limit on interest rate cuts as a form of economic stimulus.

With the overnight rate reaching the zero-bound in the spring of 2009, conventional easing could no longer be performed through the lowering of nominal interest rates, and the BoC turned instead to targeting real interest rates in an effort to further stimulate economic growth. Real interest rates are merely the nominal interest rate minus expected inflation, and while central bankers have generally proven reluctant to take nominal interest rates into negative territory, negative real interest rates can be targeted in an effort to further stimulate borrowing when nominal rates are already at the lower bound.

To illustrate by way of example, if nominal rates are set at 0.25% and the public expects an inflation rate of 2%, then the difference of -1.75% represents a negative real interest rate which effectively allows borrowers to pay back the original loan plus interest with depreciated money at a net loss to the lender and net gain to the borrower. When negative real interest rates become manifest, borrowers become more eager to take out loans which provides further stimulus for the economy when nominal rates can no longer be reduced. Because the real interest rate is the nominal rate minus inflation, in a world where nominal rates are already at the zero-bound, the only way to further drive down real interest rates is to increase inflation expectations among the general public.

With the overnight rate finally reaching the zero-bound in April of 2009, the BoC at last began their first and only foray into true unconventional monetary policy in response to the Great Financial Crisis through the implementation of “forward guidance”. This policy tool took the form of an explicit pledge to maintain interest rates at the lower bound until June of 2010 in an effort to increase inflation expectations and thus drive down the real interest rate. By stating their intentions to hold rates low for longer, the BoC effectively increased the market’s perception of future inflation in a bid to stimulate both spending and investment as they attempted to drive the real interest rate lower. In effect, forward guidance was being used as a form of unconventional policy ease at a time when conventional monetary policy had been exhausted due to zero interest rate policy.

The BoC’s response to 2008 was thus one of reducing interest rates to the zero-bound and subsequently resorting to a policy of forward guidance to further stimulate borrowing and spending. In a future financial panic even larger than that of 2008-2009, variations of these policies can be expected to be re-enacted once again, but with far less effect than what was experienced in Canada over the course of the last crisis. The BoC’s overnight rate today is far closer to the zero-bound than it was at the beginning of the 2008 panic, leaving relatively little room for further conventional easing through a reduction in the BoC’s overnight rate.

Forward guidance, similarly, will likely be insufficient by itself in raising inflation expectations to a large enough degree to truncate the deflationary forces unleashed through a large-scale economic recession brought about by a collapse in the Canadian housing market. Other forms of unconventional monetary policy will most certainly be required, leaving the BoC in relatively uncharted waters with respect to the dry powder remaining in its unconventional monetary policy toolkit.

Negative Interest Rates: A Brave New World

It is generally assumed that the zero-bound serves as a hard lower limit for the overnight rate since central bankers are either unwilling or unable to push down nominal interest rates firmly below zero. In 2015, however, the BoC conducted a study into the experiences of several European countries who had begun experimenting with negative interest rates following the 2008 crisis, concluding that while in theory negative nominal interest rates would cause the general public to flee bank deposits into zero-yielding physical cash, in practice there was no corresponding increase in the demand for physical currency in countries where nominal rates were pushed decidedly negative.

It turns out that there are significant benefits to be gained by those members of the general public who maintain deposits within the banking system, even if those deposits continue to lose money on a daily basis due to negative rates. Because of the convenience that modern banking has on facilitating economic transactions as well as the fact that large amounts of cash must still be stored and insured through other means, people are not generally quick to shift into physical cash even when nominal interest rates are less than zero. The BoC concluded that nominal interest rates could therefore theoretically be taken past their previous 2008 lows of 0.25% to a new lower bound, which they estimated at the time to be approximately -0.5%, roughly the cost of insurance and storage for large cash amounts.

As long as the costs from negative interest rates were less than the costs of both storage and insurance of large balances of physical cash, the BoC mused that they might be able to take rates even further into negative territory as a “fee” on depositors for the convenience of holding both savings and checking balances within the banking system. The BoC study did of course warn of the danger of triggering a full-blown flight to cash through an abrupt decline in the use of bank deposits brought about by negative interest rates, but this did not stop them from officially incorporating negative interest rate policies into their existing emergency framework which they updated in December of 2015. The BoC’s commitment to this policy as a potential tool of monetary ease was further reinforced by a subsequent study in 2017 outlining the benefits of negative nominal interest rate policies among countries more closely resembling Canada than the United States. Nevertheless, the authors were quick to point out the untested nature of these policies and the potential complications posed by commercial banks who were in reality slow to pass on negative real interest rates to depositors.

Negative nominal interest rates, then, represents a path of further central bank easing once rates have already been taken down to the zero-bound. As long as savers are willing to suffer daily losses on their deposits, the BoC can further stimulate lending and borrowing through negative nominal rates to the extent that depositors do not actively choose to flee into zero-yielding cash. While there has been some advocacy within certain circles for governments to actively pursue measures to prevent a flight into cash by the general public as a means to further enhance negative interest rate policies, so far the BoC has not publicly stated any intention to undertake such pursuits.

Regardless, it should be expected that negative interest rate policy will at some point be enacted by the BoC during an economic crisis where forward guidance no longer proves sufficient to lower real interest rates in a manner that offsets the deflationary forces of a full-blown collapse in the residential real estate market. Negative nominal interest rates are merely an extension of central bank easing through the overnight rate which includes, first, a period of zero-interest rate policy, followed next by forward guidance to drive real interest rates negative while nominal rates are held at the zero-bound, and lastly by the overt enactment of negative nominal interest rates to punish savers in an attempt to drive commercial bank lending higher. Given the magnitude of the economic contraction approaching and the limited capacity of the BoC to respond using conventional monetary policy in the current low-interest rate environment, the reader should soon expect negative interest rates to become a common fixture in Canadian finance.