The Bank of Canada Playbook – Part 2

With little capacity for the Bank of Canada’s to provide significant economic stimulus through a reduction to their already rock-bottom trend setting overnight rate, the undertaking of unconventional monetary policy (UMP) by the BoC during the next economic down cycle seems all but a foregone conclusion. Part 1 of this series served to examine the BoC’s current framework for unconventional easing through a reduction of the overnight rate to below the zero-bound using negative nominal interest rates. This article will explore the final piece of the BoC’s current UMP framework through the lens of its asset purchase program of 2008-2009 as well as its subsequent funding of the Federal Government’s “Prudential Liquidity Management Plan” (PLMP) in the years shortly following.

While it is true that bond purchases were indeed undertaken by the BoC during the 2008-2009 crisis, its ultimate purpose was to support asset prices in order to prevent their liquidation at fire-sale prices and to counteract the seizing-up of debt markets as a consequence of the global banking crisis (see The Great Canadian QE Myth – Part 1). The process by which the BoC purchased assets on a “sterilized” basis during the Great Financial Crisis can more readily be described as the BoC facilitating the continued smooth operation of the banking system during a time of acute financial strain rather than an explicit attempt at QE or some other type of UMP. Many commentators today are eager to point to the fact that the BoC became a large buyer of bonds in 2008-2009 and erroneously declare this to be a classic example of “Canadian QE”, but both by its practical implications and its desired intent, such a characterization can only be described as a gross and unsubstantiated exaggeration of BoC policy.

While it is true that many critics are incorrect to label the 2008-2009 asset purchase program as Quantitative Easing (QE), it is nevertheless clear from past BoC communication and studies that they are more than willing to undertake a legitimate program of QE if so required in the future. In the period following the Great Financial Crisis, the BoC began to conduct studies into the effects of QE on what they term “small open economies” such as Switzerland, Sweden, and the United Kingdom in an effort to more closely model the implications of QE on the Canadian economy. The results were hardly surprising, as the study concluded that in each of these economies, QE performed a similar function as in the US and Europe, serving to ease financial conditions by stimulating aggregate demand, devaluing the currency, and changing expectations of both inflation as well as the direction of future interest rates. While the remainder of this article discusses the various channels by which the BoC expects QE to ease financial conditions in the midst of a widespread financial crisis, it deliberately says nothing about the merits of these beliefs nor the likelihood that it will ultimately achieve its desired policy objectives in any meaningful or lasting way.

The Many Faces of QE

It is important to note that QE can be implemented in Canada in one of two ways, each with differing transmission mechanisms to the broad economy. If the BoC chooses to purchase assets directly from the private commercial banks, it does so by taking these assets out of the private sector and paying the various commercial banks with settlement balances, also called “reserves”. Because reserves are money spent by banks amongst themselves within the banking system and not spent into the broad economy, this type of asset purchase is not inherently inflationary, even though the BoC in fact creates these bank reserves out of thin air. Under this process, the BoC supports or increases the prices of assets it purchases while simultaneously driving down yields and increasing liquidity within credit markets. This is similar to how the BoC purchased assets from commercial banks during the 2008 Great Financial Crisis, although as was previously explained in The Great Canadian QE Myth – Part 1, the reserves used to fund the purchases were ultimately “sterilized” to prevent a large reduction in the BoC’s trendsetting overnight rate.

The second way that the BoC undertakes QE is through the purchase of assets from the non-bank private sector, including both institutional investors and the Federal Government itself. This is similar to what occurred as part of the Government of Canada’s “Prudential Liquidity Management Plan” discussed in The Great Canadian QE Myth – Part 2. Under this framework, the BoC buys assets from non-bank institutions and in exchange creates both deposit money for the seller of the asset as well as reserves for the bank at which the seller of the asset holds their account. For example, if the BoC purchases a mortgage-backed bond from a pension fund, it pays for this purchase by writing a check against itself and gives this check to the pension fund in exchange for the bond. The pension fund then deposits this check into its account held at a commercial bank which serves to create deposit money for the pension fund which correspondingly adds to the money supply. The commercial bank then takes this check to the BoC which subsequently credits bank’s reserve account as well. In this way, then, the BoC has created out of thin air new deposit money for the pension fund which increases the money supply, and an equivalent amount of bank reserves for the commercial bank which does not add to the overall money supply. The net result is an increase in the money supply exactly equivalent to the value of the asset purchased – a process that is inherently inflationary.

Yield Suppression and the Signaling Channel

In both cases the process of QE serves to increase the price of the purchased bond and correspondingly reduce the yield, thus impacting longer-term interest rates and reducing the cost of borrowing for the general public beyond merely the very short term. In theory, this reduction of the interest rate serves to further stimulate bank loan growth as borrowers take advantage of newly lowered rates to engage in longer term investments. The reduction in longer term interest rates also functions as a signal to the market regarding the future path of short term interest rates, as the BoC believes that QE sends a credible signal to the market that short-term interest rate increases are unlikely to be pursued in the foreseeable future so long as policy-makers are actively suppressing long-term rates simultaneously.

In a way, QE serves as a form of forward guidance to the market, with policy-makers at the BoC clearly believing that QE can be used as a policy tool to reinforce their commitment towards “lower for longer” interest rate policies. As was previously explained in The Bank of Canada Playbook – Part 1, an implied commitment of continual low interest rates via forward guidance increases inflation expectations which subsequently reduces real interest rates (the real rate is the nominal rate minus inflation expectations). This serves to further provide economic stimulus via negative real rates in an environment where the BoC has already dropped interest rates either at or close to the zero-bound.

Hot Potatoes and The Portfolio Rebalancing Channel

But the stimulative measures provided through QE are not limited to merely forward guidance or to reducing the yields for the bonds which it directly purchases. Rather, one of the BoC’s primary objectives in undertaking QE is to lower yields across the spectrum in similar assets of various maturities. When QE is undertaken in a way that creates deposit money in the non-bank private sector, the BoC receives the bond, and the seller of the bond receives newly printed money. By adding new money to the financial system and simultaneously removing an asset (the bond), there is suddenly more money chasing fewer financial assets, which creates a phenomenon where the receivers of these new funds scramble to invest it amongst a diminished pool of available assets.

The BoC refers to this form of easing as stimulus via “portfolio rebalancing”, theorizing that investors who had previously held the bonds which are now owned by the BoC still wish to hold similar fixed-income securities and will thus allocate their newly printed funds to alternative debt instruments throughout the existing bond universe. This serves to raise the prices of various bonds more generally while reducing borrowing costs across the spectrum. The experiences following the Great Financial Crisis, however, show that the effect of QE was not limited merely to the fixed-income market. Investors did not simply allocate their new funds across different types of bonds of different maturities, but instead re-balanced their portfolios into entirely different asset classes altogether.

By flooding the system with new liquidity which flowed into other asset classes such as stocks, Central Bankers were attempting to bid up the prices of existing assets via the creation of new high-powered “hot potato” money. This is the process by which newly-printed funds suddenly seeking a home are used to bid up the prices of financial assets across the spectrum in an attempt to foster a “wealth effect” among the general public. The theory behind the wealth effect is that as the general public sees the value of their assets and investment portfolios rise, they begin to feel wealthier which causes them to increase spending and engage in further consumption-based borrowing. The empirical support behind the wealth effect during periods of extreme deleveraging is tenuous at best, but this phenomenon, along with fostering fears of inflation, has traditionally been the method by which policy-makers attempt to manipulate the spending psychology of the general public.

The Exchange Rate Channel

When the BoC chooses to undertake QE in order to reduce interest rates through the various channels described above, the drop in domestic interest rates relative to other countries causes the value of the Canadian Dollar to fall as investors shift investments towards those countries with more attractive returns on cash and fixed income. Indeed, BoC studies have also shown that smaller economies have tended to experience currency depreciation immediately following announcements of QE, rather than during the actual implementation of QE itself. By reducing the value of the Canadian Dollar, the BoC subsequently increases the cost of imports into the domestic economy which raises the price of goods and services for the general population. As already described, the act of increasing inflation expectations reduces real interest rates which theoretically serves to increase borrowing and consumption and consequently provides additional stimulus throughout the Canadian economy.

And yet the purposeful devaluation of the Canadian dollar serves not only to increase the cost of imports, but correspondingly acts to decrease the costs of exports to foreigners purchasing Canadian goods and services. By reducing the cost of Canadian-made products to overseas consumers, a fall in the value of the dollar subsequently stimulates the Canadian export sector, serving to “steal exports” away from competing countries. While this type of economic stimulus has historically resulted in tit-for-tat currency wars as other countries subsequently move to devalue their own currencies to maintain competitiveness, it is nevertheless one of the channels that will likely be heavily relied upon by the BoC according to its current unconventional monetary policy framework. Because of Canada’s status as a trading nation and given the relatively small size of the domestic economy, the export sector tends to constitute a disproportionately large proportion of the Canadian productive sector. Stimulating exports through a BoC-engineered decline in the Canadian dollar may therefore more readily transmit larger benefits to the broader economy.

What the Bank of Canada Worries About

The primary concern of the Bank of Canada regarding the potential implementation of QE is that the size and duration of its asset purchase program will be constrained by the relatively small size of the Canadian debt market. Because QE involves the purchasing of debt instruments in the open market, a lack of available bonds may result in the Government of Canada debt market becoming illiquid as a result of large-scale BoC asset purchases. Indeed, the experience in Sweden is often cited as a historical example of a small economy being QE-constrained due to an increasingly illiquid government debt market in which the country’s central bank begins to crowd out private sector buyers. Similarly in the UK, the Bank of England experienced periodic difficulties finding willing sellers of gilts as debt markets also experienced illiquidity in the midst of large-scale asset purchases by the BoE.

The BoC, of course, can potentially work its way around this problem by simply imploring the Government of Canada to issue new debt for the BoC to purchase as part of continual QE. But government officials are also very well aware of the negative perception that comes along with a widespread belief by the general public that the BoC is simply monetizing government deficit spending for as far as the eye can see. While the BoC may in fact need the GoC to run large fiscal deficits to compliment an increasingly large QE program, both the government and the central bank are only likely to pursue these policies as a final and desperate last resort given the risks inherent in a widespread loss of public confidence.

The relatively small size of the Canadian debt market also provides further limitations on the ability of QE to transmit easing through its “Portfolio Rebalancing” channel. While the BoC would certainly like investors to deploy their newly-created money into other domestic debt securities to reduce yields across the spectrum, capital is highly mobile and the pool of foreign bond substitutes is relatively large compared to the Canadian domestic debt market. In this case the easing effects of QE may “leak” abroad to other countries and as a consequence have a much smaller depressing effect on domestic interest rates than would otherwise be hoped for.

It is clear, then, that any future QE undertaken in Canada will be relied upon to ease domestic financial conditions through a broad array of channels, although he likelihood that these polices will be successful is clearly a much more contentious debate. Lessons from the 2008 financial crisis have cast serious doubts on the effectiveness of past QE programs, although the BoC continues to promote such polices as potential tools in its UMP toolkit. The evidence in Canada is understandably lacking since unconventional monetary policy was largely untested during the 2008-2009 period with the exception of the limited use of forward guidance in 2009.  Given the breadth and magnitude of the recent run-up in the Canadian real estate market, however, the risks to the economy are far greater than they were at the time of the 2008 Great Financial Crisis. As such, it is almost assured that the BoC will be forced before long to pursue some combination of UMP as they attempt to respond to a renewed economic downturn while already so close to the zero-bound.