Bank of Canada opens door to negative interest rates as oil, dollar sink 

TheGlobeAndMail.com
Dec. 8, 2015
David Parkinson and BARRIE Mckenna

The Bank of Canada has restocked its emergency kit to defend the Canadian economy against major shocks, including indicating that it would consider pushing interest rates as much as a half percentage point into negative territory in the event of a crisis.

But Governor Stephen Poloz stressed that the central bank’s new framework for using negative interest rates and other unconventional monetary policies, which he introduced in a speech Tuesday, does not mean the bank is preparing to use any of these measures – even as the country deals with the aftershocks of the collapse in the price of oil and other commodities.

“Today’s remarks should in no way be taken as a sign that we are planning to embark on these policies,” he told an Empire Club of Canada luncheon in downtown Toronto. “We don’t need unconventional policy tools now, and we don’t expect to use them. But it’s prudent to be prepared for every eventuality.”

The unveiling of the central bank’s new unconventional-policy framework comes after a week of distressing developments affecting Canada’s still-fragile economy. Oil prices plumbed six-year lows, sending the Canadian dollar to its lowest level against its U.S. counterpart in 11 years. Prices of other resource commodities also slumped, contributing to a 5-per-cent sell-off of the Toronto Stock Exchange in the past five trading days.

And all this is taking place just days before the powerful U.S. Federal Reserve looks likely to raise its key interest rate next week for the first time since before the Great Recession.

Most of the world’s central banks, including Canada’s, have been cutting rates. A Fed hike will mark a major divergence in global interest rates that is already sending tremors through the world’s stock, bond, commodity and currency markets.

Nonetheless, Mr. Poloz said Tuesday that he remains convinced that Canada’s economy remains on track for a continued recovery in 2016.

“I think we’ve got all the ingredients of a recovery in place,” he said in a news conference after the speech. “It’s being masked right now, to some degree, by the declines especially in the energy sector, but also in other resource areas.”

The Bank of Canada published new guidelines for using tools other than traditional interest rates – collectively known as unconventional monetary policy – to deal with economic crises at times when interest rates are near zero. The document updates a framework the bank introduced in April, 2009, as the global financial crisis still raged.

After years of persistently low interest rates not just in Canada but worldwide, and with economic trends pointing to a continuation of historically lower-than-normal rates for years to come, unconventional monetary tools have become increasingly common among the world’s central banks to stimulate economies. With the Bank of Canada having halved its own key rate to a historically thin 0.5 per cent after two rate cuts this year, it looked long overdue to address its guidelines on using unconventional measures.

“It’s been several years since we put them out. We knew they needed updating, based on our research and the experience in other countries,” Mr. Poloz said. “We’re making sure that our tool kit is up-to-date.”

The guidelines spell out several unconventional options the bank would consider, including large-scale asset purchases (known as quantitative easing), providing explicit statements about future policy intentions (forward guidance) and the funding of credit to specific sectors – all of which have proven to be effective, to varying degrees, in lowering market interest rates and providing economic stimulus. The Bank of Canada was a global pioneer in using forward guidance during the 2008-09 financial crisis, but unlike other central banks, it hasn’t tried any of the other unconventional tools it lays out in the guidelines.

Perhaps the most intriguing new wrinkle is the central bank’s calculation that the effective bottom (or “lower bound” in central-bank speak) for its interest rate is not zero, but rather negative-0.5 per cent. In its 2009 framework, it had considered 0.25 per cent to be its effective lower limit, which matches the record low of the bank’s key rate during the financial crisis.

But recently, a growing number of central banks, particularly in Europe, have resorted to negative interest rates – with no apparent ill effects. Just last week, The European Central Bank lowered the rate on its deposit facility to negative-0.3 per cent.

Commercial banks are willing to accept negative rates on their deposits with the central bank because there are considerable costs associated with the holding and storing of large volumes of currency – effectively, they are willing to pay central banks to hold it for them.

“This is a good change [that] they finally got around to acknowledging that they could go beyond zero,” said Carleton University economics professor Nicholas Rowe, who specializes in monetary policy. “What’s made it obvious is that so many other central banks are doing just that.”

It also implies that the current level of 0.5 per cent still leaves the bank with more room for additional cuts than many people had assumed.

“We now believe we have roughly 100 basis points worth of room underneath our current interest-rate setting,” Mr. Poloz told the news conference.

“This could be a signal that deflation is not a serious threat, because there are ways for monetary policy to keep up the fight,” McGill University economist Christopher Ragan said. He argued that this suggests there is no reason for the central bank to raise its current 2-per-cent inflation target – something the bank has been contemplating as it prepares for the renewal of its five-year inflation-targeting agreement with the federal government next year.

Still, Mr. Poloz insisted repeatedly Tuesday that the central bank doesn’t see any need to resort to negative interest rates, or any other unconventional policy tools, in the current economic environment – despite the latest battering of commodity prices and the Canadian currency.

Mr. Poloz insisted that the economy is still on track to return to full capacity “around mid-2017,” unchanged from the bank’s most recent economic forecast in October. He argued that the most recent reading of gross domestic product, which showed that the economy contracted by 0.5 per cent in September, was due to short-term “special factors,” most notably a fire that shut down most of the production at the huge Syncrude Canada Ltd. oil sands facility for the month.

“The overall economy is growing again, even as the resource sector contends with lower prices, because the non-resource sectors of the economy are gathering momentum,” he said in his speech.

He noted that the stimulative effects of the bank’s earlier rate cuts and the weaker Canadian dollar haven’t fully worked their way into the economy. On the rate cuts in particular, he said, the impacts “are still probably only half there. It will take another year for all those effects to come through.”

“We need to be a little bit patient here,” he said.

However, he also acknowledged one of the lessons of the post-crisis era is that monetary policy is less effective once interest rates reach ultralow levels. “Fiscal policy tends to be a more powerful tool than monetary policy in such extreme circumstances,” he said.

The new Liberal government is vowing to spend billions on infrastructure projects to help kick-start the economy, and will go into deficit for at least two years to pay for it. That could take much of the pressure off the Bank of Canada to have to resort to negative interest rates and other unconventional policies.

“It’s not very likely if we have a federal government prepared to use fiscal stimulus if things get worse,” said Avery Shenfeld, chief economist at Canadian Imperial Bank of Commerce.