On the face of it, the Bank of Canada has done absolutely nothing for nearly 4 years now, and most people think it won't do anything until sometime next year. The target of the overnight rate has stayed at 1% for a very long time.
This is very puzzling. I do not understand it.
But maybe the Bank of Canada has not been doing nothing for the last 4 years. Maybe it has been actively managing monetary policy by varying the length of its commitment to do nothing.
1. Why is it puzzling that the Bank of Canada has kept the overnight rate at 1% for 4 years?
It is very puzzling when we compare it to historical experience, during the modern era of targeting 2% inflation. The Bank of Canada usually adjusts the overnight rate much more frequently than once every 4 years.
It is very puzzling when we compare it to what theory says the Bank of Canada should be doing. Theory says the Bank of Canada needs to adjust the overnight rate in response to the information on inflation, unemployment, and lots of other things, to keep inflation at 2%.
Maybe it's just a sheer fluke. If nothing had happened for 4 years, or if the things that did happen all just cancelled out by sheer chance, then the Bank of Canada wouldn't have needed to change its target for the overnight rate, and so didn't change it. We can't rule that out. But it would be a fluke.
Maybe the Bank of Canada just got lazy. It should have been doing something, but there was some special reason why it didn't like change. And so the economy wandered away from the path it should have been following and would have been following if the Bank of Canada had been doing what it should have been doing.
But theory says that using an interest rate as an instrument to target 2% inflation is an unstable system. So if you hold the steering wheel fixed, and don't adjust it in response to shocks, you don't just miss the 2% target, but you miss the 2% target by ever-increasing amounts. That hasn't happened. So either the theory is wrong, or it was just a fluke that there were no shocks, or all the shocks just cancelled out, so the car stayed on the road despite the driver being asleep at the wheel.
That's why it's a puzzle.
2. But maybe the Bank of Canada was using "forward commitment" to control the economy.
Let me first explain "forward commitment".
Here is the "standard model" of how the Bank of Canada operates monetary policy. There are 8 "Fixed Announcement Dates" per year. At each FAD, the Bank of Canada looks at the information and announces the overnight rate target until the next FAD.
It is easy to imagine a slight variant on that standard model. At each FAD, the Bank of Canada announces the overnight rate target that will be implemented at the next FAD. There is a one-period lag in implementing the new overnight rate target, in other words. Because consumption and investment decisions depend on medium- and long-term interest rates, and those medium- and long-term rates depend on expected future short-term rates, as well as on current short-term rates, there is no reason why such a policy could not work about as well as the standard model. Provided the Bank of Canada's commitment is credible, so people believe that promise.
What we are talking about should really be called "forward commitment" rather than "forward guidance", because the Bank of Canada is making a promise, rather than just a prediction, about its future actions.
If the Bank of Canada always used the same one-period lag in setting the overnight rate, it would still only be making one decision per period. It would not really be deciding this period what this period's overnight rate will be; it is merely implementing its previous period's promise. It still has only one degree of freedom per period.
But we can imagine a variant, where the Bank of Canada switches back and forth between those two ways of setting the overnight rate. If initially it is setting the overnight rate in the current period, and then switches to setting the overnight rate for the following period, at the time of the switch it will be setting both the current and the future overnight rate. It will have two degrees of freedom that period. And if sometime in the future it switches back to setting the overnight rate for the current period, it will have zero degrees of freedom that period.
And we could imagine the Bank of Canada using forward commitment to set the overnight rate two periods in advance, or three, or four, or whatever.
And we could imagine it "borrowing" degrees of freedom from the future, when it uses more and more forward commitment, and "repaying" those borrowed degrees of freedom when it switches back to using less and less forward commitment.
OK, that is "forward commitment".
3. I'm now trying to apply that perspective to the last 4 years.
When the Bank of Canada raised the overnight rate to 1%, 4 years ago, it thought that was the right decision, and also thought it would need to raise it again fairly soon. But the recovery was slower than expected. The Bank of Canada regretted having raised the overnight rate so much so soon. But it cannot change its past mistakes. The only decision it faces is what to do now, given the information it has.
It is perfectly possible of course, that a succession of slightly disappointing news would tell the Bank of Canada to leave the overnight rate exactly at 1%, rather than slowly raising it as planned, or cutting it again, and then raising it later. But that would be a fluke. And I want to explain what happened without resorting to flukes.
If the economy turned out to be much weaker than expected, and the Bank of Canada needed to loosen monetary policy, there are two ways it could do it: it could cut the overnight rate below 1%; or it could lengthen its commitment to keep the overnight rate at 1%.
The Bank of Canada has not been doing nothing for the last 4 years. It has switched to doing things by forward commitment. But it is a strange form of forward commitment, because what it varies is not the promised level of the future overnight rate but the future date at which the overnight rate may increase.
For example, suppose the Bank of Canada commits to keeping the overnight rate at 1% for the next 3 FAD's. And people think there is a 50% probability it will extend that commitment for another 3 FADs at the next FAD. And people expect that when the commitment runs out the Bank will raise the overnight rate.
If at the next FAD the Bank of Canada commits to keeping the overnight rate at 1% for the next TWO FAD's, that is a tightening of monetary policy, relative to what was expected. But if at the next FAD the Bank of Canada commits to keeping the overnight rate at 1% for the next THREE FAD's, that is a loosening of monetary policy, relative to what was expected.
And what matters for long-term interest rates is what the Bank of Canada does, relative to what was expected.
If it wants to tighten monetary policy, it brings forward the date at which it says it may increase the overnight rate. If it wants to loosen monetary policy, it pushes back the date at which it says it may increase the overnight rate.
But there is a limit on how quickly you can bring forward the date at which you may do something, if you want to keep your credibility.
For example, if at one FAD you promise to do nothing for the next 3 FAD's, and the next FAD you promise to do nothing for the next 2 (or more) FADs, your promises are mutually consistent.
But if at one FAD you promise to do nothing for the next 3 FAD's, and the next FAD you promise to do nothing for the next 1 (or less) FADs, your promises are not mutually consistent. (Today I promise to stand still for 3 days, but tomorrow I promise to stand still for only 1 day.) You have failed to reconfirm your previous commitment.
Suppose, at each Fixed Announcement Date, you make a promise to do nothing for the next X Fixed Announcement Dates, where X can vary from one FAD to the next. So there is a sequence of promises X(t). Provided, at each date t, there is no previous date t-i, such that X(t-i) > X(t)+i, your promises are mutually consistent.
If I am right about this, then the Bank of Canada has been managing monetary policy by actively changing its forward commitment to do nothing for the next X Fixed Announcement Dates, by varying X over time. Provided it does not shorten X too much from one FAD to the next, each commitment can remain credible, because it is not inconsistent with previous commitments.
5. But there's still a puzzle.
Why did the Bank of Canada switch to using this style of forward commitment, rather than tightening or loosening monetary policy the old-fashioned way, by raising or lowering the current overnight rate?
6. I don't know.