An Operational Perspective on QE in Canada

Canadian market-watchers generally consider Quantitative Easing (QE) as the bazooka that was never fired by the Bank of Canada (BoC) during the financial crisis of 2008. In contrast with many other countries such as the US, Japan, and the EU, Canada was never forced to engage in unconventional monetary policies such as QE, as stresses in the Canadian financial system were ultimately resolved with conventional monetary policy measures and other short-term emergency liquidity injections which were eventually withdrawn by 2010. Many people have therefore come to believe that QE constitutes the biggest monetary policy hammer in the Bank of Canada’s toolkit should a large-scale financial crisis once again threaten the stability of the Canadian financial system.

In brief, Quantitative Easing refers to the process by which a country’s central bank creates reserves in the banking system and transfers these reserves to the banks in exchange for assets such as government bonds. One of the purported benefits of QE is that it serves to increase very liquid reserve balances in the banking system and in doing so entices banks to increase lending to the private sector and take on longer-term less-liquid assets (ie. make loans). The point of this article is not to debate the merits of QE or question its efficacy in reaching its stated goals, but to understand from a practical perspective the implications of implementing QE in Canada specifically.

In practice, the implementation of QE in Canada would require a significant operational change to the way monetary policy is conducted by the BoC, as dramatically increasing reserves in the Canadian banking system is not possible without significant changes to the BoC’s operational framework, currently implementing what is referred to as a “corridor system”. Presently, when the BoC sets the headline interest rate at its regular meetings, what it is really doing is setting the target for the “Overnight Rate”, which is the midpoint between something called the “Deposit Rate” and the “Bank Rate”. The Deposit Rate is simply the interest rate that the BoC pays banks for reserve balances which they hold at the BoC, and the Bank Rate is the interest rate that banks must pay to borrow reserves from the BoC. The Overnight Rate simply reflects the interest rate that banks pay to borrow reserves from one another.

Because banks can always earn the Deposit Rate by keeping reserves at the BoC, they have no incentive to lend reserves to other banks at a lower rate; and because banks can always borrow reserves from the BoC at the Bank Rate, they have no incentive to borrow reserves from other banks at a higher rate. Under this structure, banks with excess reserve balances will always try to lend reserves to banks at a higher rate than the Deposit Rate, and banks with a deficit position will always try to borrow reserves from other banks at a lower rate than the Bank Rate. Thus, the Deposit Rate forms the lower bound of the corridor, and the Bank Rate constitutes the upper bound. Banks lend reserves to one another somewhere within this corridor, with the Overnight Rate usually landing somewhere close to the mid-point of this range.

When the Overnight Rate deviates from the mid-point target within the corridor system, the BoC intervenes by adding or removing reserves balances in order for the Overnight rate to hit its target. When the BoC adds reserves to the banking system, it increases the supply of reserves which necessarily lowers its price (the overnight interest rate). Similarly, when reserves are removed from the banking system by the BoC, this reduces the supply of bank reserves and therefore increases its price (again, the overnight interest rate). It should be obvious from the above description that a large-scale increase in the supply of reserve balances (the very definition of QE) will serve to dramatically reduce the price of reserves, causing the Overnight Rate to crash below the BoC’s target. QE will effectively render the current corridor system ineffective at dictating monetary policy in Canada, forcing the BoC to abandon its current monetary policy framework if it wishes to engage in QE while at the same time having control over its trend-setting interest rate.

Ultimately, the implementation of QE in Canada will have the effect of forcing the Overnight Rate to the bottom of the corridor, meaning the Deposit Rate effectively becomes the Overnight Rate. Thus, for the BoC to set monetary policy while at the same time conducting QE, they will be throwing away their corridor system in exchange for a “floor” system. This is a system very much like the post-2008 system adopted by the United States in which the interest rate that central banks pay on excess reserves effectively becomes the de facto Overnight Rate. Under a floor system, the BoC sets the target policy rate by simply setting the Deposit Rate to equal the target rate, a process entirely independent of the amount of reserves in the system.

Because the interest paid on reserves by the BoC to commercial banks reduces income returned to the Government of Canada (since the BoC returns profits to the treasury), one can reasonably predict that a massive increase in reserves due to QE will likely open up renewed accusations of taxpayers providing a “subsidy” to private banks. But is this really accurate? After all, the commercial banks previously had higher-yielding government bonds, but due to QE, they now have a lower-yielding bank reserves instead which in aggregate reduces bank income. Is this really helpful to the banks?

Furthermore, interest that the Government of Canada was previously paying to the commercial banks is now being paid to the BoC as a result of QE, but these interest payments are simply remitted back to the treasury as BoC profits, which is actually a net benefit for the taxpayer. The implications to the taxpayer therefore seems surprisingly neutral, or at least not as bad as they might seem at first glance. The government basically gets an interest-free loan, but gets penalized via reduced profits from the BoC due to it now having to pay the Deposit Rate on a huge quantity of reserves. From a fiscal point of view, QE seems like a relative non-event.