With the recent emergency response to the COVID-19 pandemic, the Bank of Canada (BoC) has managed to expand its balance sheet in a truly unprecedented manner by purchasing an enormous quantity of assets from the private sector. In layman’s terms, the BoC has essentially been buying up every type of bond under the sun in an attempt to keep asset prices high and reduce interest rates throughout the broad economy. In exchange for these assets, the BoC has been creating a lot of bank reserves (called settlement balances) within the banking system.
In Canada, controlling the quantity of settlement balances has traditionally been how the BoC impacts their key overnight rate. To describe this process at a very high level, the BoC has traditionally implemented something called a “corridor system” by which they set an upper and lower band for interest rates. Banks are given incentives to lend settlement balances to one another at the mid-point of this band, and if rates begin to deviate from the mid-point dramatically, the BoC traditionally intervenes. If the overnight rate is too low, the BoC will decrease the quantity of settlement balances in order to increase rates, and if the overnight rate is too high, the BoC will increase the quantity of settlement balances in order to decrease rates.
There’s a concern among some commentators that in order to raise interest rates in the future, the BoC will need to decrease the quantity of settlement balances in the system, which means selling off assets from its balance sheet in order to drain reserves. But selling off assets may be the last thing the BoC wants to do, as it would remove the support for bond prices and thus cause interest rates to spike across the board. In the situation envisioned, a sudden spike in inflation would cause the BoC to flood the bond market with securities from its balance sheet, dramatically raising borrowing costs for both the private sector and the government.
While the above scenario is all well and good, it really has little bearing with reality since the Bank of Canada no longer implements the “corridor system” outlined above. The BoC’s emergency response to COVID-19 resulted in a flood of newly created reserves into the banking system, forcing policy-makers to change from a “corridor system” to a “floor system”. I described this change in detail in my September 2019 article An Operational Perspective on QE in Canada far before the BoC’s emergency measures even took place. The article attempted to explain that any implementation of future QE-like operations in Canada would force a change in the way the BoC operates monetary policy.
I don’t intend to rehash the entire article here (readers can refer to the previous article for the details), but suffice to say that the ability of the BoC to set interest rates is now entirely divorced from the amount of reserves in the system. The BoC can now increase interest rates by raising its “deposit rate”, which is the rate it reimburses banks for maintaining reserve balances at the BoC. It no longer needs to adjust the level of settlement balances in the system through open market operations. In other words, the deposit rate is now the de facto overnight rate.
In summary, it’s fine to wonder whether the BoC will practically ever be able to unwind their balance sheet, but the point is that there’s nothing really forcing them to do so from the perspective of setting monetary policy. Currently the Bank of Canada is sticking to their story that their balance sheet will unwind organically over time as issues mature. This might be the case, but it might not be. Does it really matter? If financial conditions improve then a lot of their short-term holdings will mature in the near future and cause their balance sheet to shrink on its own. If inflation picks up unexpectedly due to increasing economic activity, then the BoC will be free to hike rates as well, independent of their bond runoff rate.