Central bankers responded to the 2008 crisis with massive support for the world’s financial system. These bold moves made heroes of U.S. Fed chairman Ben Bernanke, Bank of Canada governor Mark Carney, and their colleagues overseas. Four years later, however, major economies are still struggling. There is a troubling sense the heroes have lost their touch.
The Fed’s September pledge to keep interest rates ultra-low until the U.S. economy gets moving included a commitment to buy more long-dated government bonds and mortgage securities to push long-term yields down. Commentators and markets alike responded negatively. Not only will more bond-buying reinforce the Fed’s disconcerting role as the U.S. economy’s dominant lender, but people are increasingly asking if the goal of depressing long-term interest rates is itself wrong.
Chronically low long-term rates create problems. As Canadians are well aware, they encourage household over-leveraging, and hammer individual savers as well as the insurers and pension funds that save on their behalf. Moreover, compressing the margin between long- and short-term interest rates squeezes private-sector financial intermediation—not what a central bank trying to boost the economy should do.
Banking is famously about borrowing short and lending long. A wide gap between long- and short-term yields makes intermediation profitable, and encourages private banks to expand their balance sheets. Historically, steeper yield curves go with faster money growth and economic pickups. Flatter ones go with slower money growth and slumps. Since early 2011, the U.S. curve has flattened: the yield spread between 30-year U.S. treasury securities and three-month ones has shrunk from around 4.5% to scarcely more than 2.5%. Worse, much of that 2.5% simply reflects expectations of higher inflation over time. So this is not a promising signal for U.S. economic expansion.
U.S. policy inevitably shapes the environment for Canada. Happily, while our own yield spread has also narrowed from more than 2% in early 2011 to less than 1.5% recently, relatively stable inflation expectations in Canada mean more of that margin is real, and our money growth has been robust. Still, squeezing financial intermediation now may mean trouble for Canada in 2013 and beyond.
If Canadians can’t influence the Fed or avoid its impact on U.S. money growth and spending, what can our policy-makers do? First, the Bank of Canada should keep making short-term funds abundantly available to our banking system.
Beyond that, the Bank should avoid measures calculated to depress long-term interest rates in Canada. It has not followed the Fed in buying long-dated government securities directly. But people know that central bankers copy each other, so Mark Carney could usefully clarify that he will not go that way. And to the extent that expectations of low short-term rates indefinitely are bringing Canadian long-term rates down, the Bank must say more loudly and frequently that the overnight rate can and will ultimately rise.
The federal government can also help, by reversing the dramatic shortening of the term of its debt that followed the crisis. An announcement in late September that it will auction more 10- and 30-year bonds and reduce buy-backs through next March was a good step. Ottawa can do more: our current shallow yield makes it relatively cheap to lock in lower interest rates for years to come. And if aggressive issue of longer bonds causes market indigestion or spooks investors wary of higher inflation, the feds can issue more real-return bonds to emphasize their commitment to hold inflation down.
So while we in Canada can’t control the Fed, we don’t need to accept passively every consequence of its attempts to depress long-term interest rates in the United States. The Bank of Canada and the federal government have tools to help our yield curve recover its steeper slope. Using those tools would be good for our financial system and our economy as a whole.
William Robson is president and CEO of the C. D. Howe Institute