The central bankers of the post-crisis era are modern-day explorers, only with fan charts instead of sextants. As they like to say (repeatedly), they have been testing “uncharted waters” since the moment the U.S. Federal Reserve dropped its policy rate to zero in 2008. That represented the exhaustion of “conventional” monetary stimulus, yet the economy kept sinking. Central bankers mostly have been making it up as they go ever since.
The longer one stays at sea, the more comfortable one becomes with his or her surroundings. Same with the masters of monetary policy. They are becoming less afraid of the Great Unknown. On Dec. 7, the Bank of Canada endorsed negative interest rates as a viable emergency stimulus measure, a significant shift that demonstrates the extent to which monetary policy has evolved since the Great Recession. As official interest rates in various countries approached zero, there was talk that going negative—effectively requiring private lenders to pay to deposit their excess reserves at central banks. Theoretically, such a move could push more cash into the economy by punishing lenders for taking shelter. But those who mumbled the idea too loudly were seen as a touch mad. Canada’s central bank dismissed the possibility, stating explicitly that the target rate for overnight borrowing between Bay Street banks—the foundation of all private lending in the Canadian economy—had a floor of 0.25%. Anything lower risked screwing up financial markets, or so policy makers believed at the time.
The experience of fellow sailors caught in rougher waters caused Bank of Canada Governor Stephen Poloz to rethink the merits of negative interest rates. The European Central Bank, the Swiss National Bank, the Riksbank of Sweden and Denmark’s central bank all have set their policy rates below zero. The market disruptions that many predicted haven’t occurred. Harriet Jackson, an economist at the Bank of Canada, determined that money markets—the biggest worry of doubters—were running smoothly. “It appears that as long as there is a positive spread to encourage borrowing and lending, the absolute level of interest rates is not particularly important for intermediaries,” Jackson wrote in a recent paper on the international experience with negative interest rates. The policy may even provide a degree of stimulus, which would come as a surprise to those who assumed negative rates simply would cause a run on cash. Jackson observed that banks had resisted charging negative interest rates to customers, blunting somewhat policy makers’ intent. But the measures appeared to put meaningful downward pressure on exchange rates, which helped fight deflation and exports.
Poloz insisted in a speech in Toronto that his decision to update the Bank of Canada’s crisis arsenal should not be interpreted as a signal that he is poised to deploy negative interest rates or any other unconventional stimulus measure. He said the Bank of Canada’s two interest-rate cuts this year, in January and July, are working. Canada’s recovery from consecutive quarters of economic contraction is on track, led by non-energy exports to the United States, he said. At a press conference later, Poloz dismissed a spate of disappointing economic indicators, and he shrugged off a question about the slide of oil prices to below $38 (US) per barrel. “We mustn’t lose sight of positives,” Poloz said. Cheaper energy will leave consumers and companies in much of the world with more money to spend. “Global growth is what matters most to Canada,” as the demand will boost exports, he said.
These aren’t the words of someone bracing for a sudden storm. But Poloz’s decision to embrace negative interest rates does reveal something about the near future. In 2016, the Finance Department must renew the Bank of Canada’s marching orders. The governor of the central bank plays a significant role in the drafting of the institution’s mandate and he spends a good chunk of his research budget investigating whether there are better ways to achieve price stability. For two decades, the central bank’s job has been to keep consumer prices advancing at an annual rate of 2%. One of the questions Poloz and his deputies have been considering this year is whether they should advise the government to raise the inflation target. The reason to do so would be to create a bigger cushion if Canada’s economy ever is walloped again like it was in 2008. Theoretically, a higher inflation target would require the central bank to run a higher policy rate. In the face of a recession, the Bank of Canada would then be able to cut borrowing costs more aggressively without resorting to risky unconventional methods.
That idea was especially tempting months back when policy makers thought the lowest they could go was 0.25%. Now, based on the experience in Europe, the Bank of Canada reckons it could cut the overnight target to at least negative 0.5%, the central bank’s new effective lower bound. Suddenly, the current policy rate of (positive) 0.5% doesn’t look so daunting. As Poloz indicated in Toronto, if something went terribly wrong tomorrow, he could cut the benchmark interest rate by a full percentage point before trying something else, such as creating money to purchase bonds.
And all without changing the inflation target that a younger Poloz helped design, and that the older Poloz considers a success. “It is a very high bar for us to change,” he said.
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