What next for the Bank of Canada?

The Bank of Canada currently sets the overnight rate at 1%. Markets expect it to cut by about 50bp on Tuesday. I think it should cut to zero (or 0.25%, which is effectively zero, given the traditional spreads). I thought it should cut to zero back in December. But if it does cut to zero, or if we think that cutting the overnight rate any further will have a negligible effect, what else can or should it do?

So far, the Bank of Canada has done two main things which can be considered "unorthodox monetary policy".

First, it has bought CMHC-insured mortgages. Second, it has acted as "pawnbroker of last resort", by lending to financial institutions against a wider range of commercial paper as colateral.

These two policies are much less unorthodox than they sound.

A CMHC-insured mortgage is in effect insured by the government of Canada, since CMHC is owned by the government, and I cannot see the government failing to bail out CMHC if it needed to. So, ultimately, a CMHC-insured mortgage is not that different from a government bond. So the Bank of Canada's buying a CMHC-insured mortgae is not that different from buying a government bond in a standard open market operation.

Acting as "pawnbroker of last resort" is not so unorthodox either. A pawnbroker does not buy your watch; he lends you money, and holds your watch as colateral. You get the watch back when you repay the loan. The Bank of Canada always was prepared to lend money to banks; it now extends loans to a wider set of financial institutions, provided they can come up with some colateral.

If the Bank of Canada imposes a (say) 20% "haircut" when it acts as pawbroker, and lends 80% of the value of the colateral of the (say) commercial paper, the borrower is leveraged 5:1. The borrower alone takes on all the risk (up to the 20% haircut), and any losses in value of the commercial paper are magnified 5-fold.

The current financial crisis has two main features: the first is a shortage of liquidity; the second is a shortage of appetite for risk. Everybody wants to hold only the most liquid and most safe assets, like government bonds. The Bank of Canada's current two "unorthodox" policies may help provide liquidity (the mortgages and commercial paper are not that liquid), but it does little to help solve the shortage of appetite for risk.

A more unorthodox, and a more aggressive monetary policy, would have the Bank of Canada buy assets outright (rather than lending against them as colateral), and buy risky assets (rather than safe assets).

Now, if the Bank of Canada buys a risky asset, there's the question of which risky asset, and how much to pay?

I do not want the Bank of Canada to have to decide how much to lend to individual firms and households, and what rate of interest to charge each individual firm and household. In other words, I want it to remain a central bank, not a national bank.

The way around that problem is for the Bank of Canada to be an index fund. Buy a share of the index of all commercial stocks and bonds, for example.

This is similar to my previous (discarded) proposal that the Bank of Canada should peg the TSX-300 (except it should just buy a share of all shares, not necessarily try to target the index precisely). It is similar to Roger Farmer's proposal (except that I disagree with Roger's claim that by moving two levers the Bank can hit two targets - inflation and unemployment - since the two levers work through a single mechanism of aggregate demand, so only one target can be hit.)

There's one thing I can't decide on: should the Bank of Canada buy a percentage of the existing stock of shares and commercial paper; or should it buy a percentage of all the flow of all newly-issued shares and commercial paper?

Buying the flow of newly-issued financial assets would seem to have the biggest "bang-for-buck", if the motive is to increase investment. But then firms might game that policy by calling in existing paper and replacing it with newly-issued, if the new traded at a premium to the old. And if new and old paper were perfect substitutes in the eyes of asset holders, it wouldn't make any difference anyway, and buying the old would be quicker and easier to implement.

Comments

[bob]

hmm... I'm not so sure we need more radical monetary policies. Resisting radical monetary and banking policies is what has largely kept us out of this mess. I'd like to keep it that way: as conservative and public-utility-like as possible. I'd be pretty uncomfortable with the BoC buying assets to be honest. Seems kind of like merging a commercial bank with an investment bank. Our banks are in good shape, and thankfully we had perhaps my favorite central banker ever, David Dodge, at the helm leading up to the crisis. He never seems to get the credit he is due. Also Mark Carney seems to be doing a very good job. I think fiscal policy is probably a more fruitful strategy at this point, mainly because our central bank is doing everything that I would want them to do at the moment, but it's still not enough. I think traditional fiscal stimulus like infrastructure, grants for canadians to pursue more education if they can't find work etc. would be best. I'm gonna post a comment on the "Can Canada Recover Alone?" post before I drag this one too far off topic.

[Marc]

Nick, what do you think of the idea, advanced by David Laider in Canada and others elsewhere, that the Bank of Canada buy up federal (maybe even provincial) government debt, as a means of financing our deficits over the next two or more years, and in doing so providing the safe assets the market is demanding. And we could sleep a bit better knowing that our grandkids are not going to have to pay for saving our butts back in '09.

In normal times, we would be concerned about inflationary impacts, but these are not normal times and inflation is not the issue, deflation is. I think this would be a much better approach than having the Bank buy equities or commercial paper. And the proceeds go into things that are much needed (hello, infrastructure). Why not set off a much bigger public-sector led investment program that builds out the infrastructure we need for the next generation (heaps of public transit would be a good start, but there is more).

I know that you addressed this as a possibility in a previous post. At the time you put it as a last resort, but seems to me you've gotten more pessimistic as the crisis has deepened. So?

[Marc]

Oops, there should be a "not" between "grandkids are" and "going". Sorry.

[Fixed! - SG]

[westslope]

In an open, resource-levered economy like Canada's, does fine-tuning panic-mode monetary policy really matter? There are a number of unpriced credit market margins that the Bank of Canada cannot directly influence.

Your fellow UWO graduate David Andalfatto has an insightful and relevant blog post on this issue:

Bank of Canada Slashes Bank Rate to 1.5%

I'm inclined to agree with bob regarding his call for caution and in his praise for David Dodge. Near zero overnight rates would only make sense in face of an overwhelming threat of deflation. Canada should also resist the temptation of beggar thy neighbour policies, fiscal and monetary. Weakening commodity prices will take the Canadian dollar to where it needs to go.

[Andrew F]

I'm fairly swayed by the argument that as great as infrastructure spending would be, much of the incremental spending would be slow, and impossible due to a lack of capacity in construction.

Thus, buying a bond index is an interesting idea as far as directly injecting credit into the economy without picking winners and hopefully without too much risk. It might be a way to get firms to take advantage of M/A opportunities, etc.

[Marc]

OK, I promise to read back my comments more carefully before posting them. Re-reading Laidler, his point is to just buy up current new government debt. I'd like the government to keep issuing new debt at lower interest rates, and have the bank buy up outstanding debt issued at higher interest rates, and got those mixed when trying to summarize Laidler in one sentence. Bad economist!

I've tried to build on these thoughts more coherently in this blog post, which also has the extended quote from Laidler:
http://www.progressive-economics.ca/2009/02/27/next-steps-for-monetary-and-fiscal-policy/

[Nick Rowe]

Marc: agreed; we are not concerned about the inflationary impacts. Or rather, I am very concerned about the inflationary impacts, because I want to create some, to stop us falling below the 2% target (and I see that objective as roughly co-extensive with getting us out of the recession). The question is: what's the best way to create some (demand-led) inflationary impact? My way, or David Laidler's way? (I'm going to duck the fiscal policy question).

That's a good question. Here's a short, inadequate, reply:

The New-Keynesian Nick says: "David's wrong about this crisis. This crisis is not about the distinction between money and (government) bonds. A standard open-market operation (swapping money for bonds) is really equivalent to cutting the overnight rate. This crisis is about the distinction between money+bonds (which are close to perfect substitutes for each other at the moment) vs. all other (riskier, and less liquid) assets. We need a different sort of OMO, where the BoC sells money+bonds and buys the risky and illiquid stuff."

And then the David voice inside my head replies: "But remember, Nick, money is a medium of exchange, and bonds aren't. We need to create an excess supply of money, so that people don't want to hold it, and will lend it or spend it, so it hot-potatoes around the economy as people try to get rid of it. And it really doesn't matter how the BoC gets that excess supply of money out into the economy. It could buy bonds, shares, bicycles, or just give the stuff away; it doesn't matter. So it might as well just buy bonds, since they are safer and easier to buy."

So your question triggers a recurrence of my 32 year-old schizophrenia regarding David's view of the world, which I half share, and half don't.

Dunno.

[Nick Rowe]

Marc: a follow-up. On the grandkids issue (which generation pays to fix the crisis). To a first approximation, it makes no difference whether the BoC buys commercial paper, or whether the government runs an expansionary fiscal policy by increasing investment spending. Both provide a future asset. To a second approximation, it depends on which one is riskier, has the higher return, etc. Could go either way in principle.

But if the alternative is government deficit spending on current consumption, or on tax cuts, it is better for future generations if the BoC buys shares.

[Nick Rowe]

Marc: a third follow-up. I wrote my 2 comments above before reading your 3.17 comment. But I don't see much to change in what I wrote. The David voice in my head seems mostly consistent with the real David on paper.

But the New Keynesian Nick can't see the difference between buying new debt and old debt, if it's government debt. They should be very close substitutes. And I can't see why David would need fiscal policy in order to get an excess supply of money out into the economy. There's not a shortage of old debt for the BoC to buy.

[Marc]

Thanks, Nick. I'm reminded of Trudeau's comment that he wanted a one-handed economist. On the other hand ...

On the last point I guess there is a role for the Bank to make a squeeze play by buying older debt that pays a higher interest rate in favour of new debt that would pay a lower rate. But ultimately, what matters is the quantity of additional debt added to the market. Maybe the Bank should only buy up a share so that more debt is available to be held by a private sector seeking to hold safer assets.

[Nick Rowe]

Marc: but remember: if the BoC buys debt with money, there is less debt in public hands, but more money in public hands. And money is just as safe (safer, slightly) than government bonds.

The public has a desperate demand for money+bonds. So the BoC needs to sell money+bonds, and buy something else. Like shares, or commercial bonds. Or new bridges (through it's purchasing agent, aka the government).

[Evelyn Guzman]

You said you do not want the Bank of Canada to decide how much to lend and at what interest , but are they not already doing that? Perhaps not the Bank of Canada but the others determine who to lend money to and at what interest. The very rich gets the best deal; they get the lowest interest sometimes at prime rate minus 1%.

Evelyn Guzman
Debt Challenger