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This may be a stupid question, but why can't the Bank lower interest rates below 0% (i.e. pay people to take out money)? My gut reaction was that this would cause infinite demand for loans, but there shouldn't be infinite demand if people expect deflation, because borrowers will eventually have to repay the principle. Deflation causes prices to fall, meaning you can buy more goods tomorrow with $1 than you can today, which means that taking out a loan today and repaying the principle tomorrow means giving up purchasing power when there's deflation. Which means borrowers may need to be incentivized with a negative interest rate in order for them to borrow.

There's got to be a flaw in my logic though because it seems like all economics believe interest rates can't go below zero. I'm just wondering what my error is.

Utterly meaningless. The estimates here are useless for understanding today's situation.

Sorry to keep belabouring the same point but it just keeps coming up. IF the full-employment consumption path can only be supported with a negative real rate then we will have deflation. The reduction in today's prices relative to future expected prices sets up the inflation required to support the consumption path.


On second thought, I need to retract my last comment. The estimates could be interepreted as assesing whether the full-employment real rate is negative or not. I jumped the gun on that one.

It's strange how we used to want a steep Phillips curve, so a little bit of unemployment could get inflation down quickly, when we were trying to reduce inflation in the 1980's. And now we are hoping that it's flat. Let's hope all those Keynesians were right about downward nominal wage and price rigidity!

Good characterization of BoC policy. So what happens to the BoC's balance sheet during these policy shocks? Surely, tinkering in the overnight markets is not the only discrete policy tool, nor should it be used as a complete indicator or sufficient statistic for monetary policy.

Once upon a time,the BoC employed a monetary conditions index (MCI) if memory serves. It explicitly incorporated the exchange rate.

I would guess that the BoC still informally monitors the exchange rate. A declining Canadian dollar will to some extent offset risks of deflation. That said, measured and expected inflation may remain positive but Canadians will likely still delay significant capital purchases expecting prices to decline: houses, renovations, personal computers, etc. To abuse terminology, think of it as 'deflationary behaviour' without deflation.

The real risk of deflation is elsewhere, particularly the USA. That's the silver lining to discretionary fiscal stimulation that may not accomplish much more than rewarding special interest groups. The massive fiscal stimulation compliments and thus should reinforce expansionary monetary policy.

I see Adam is on fire with "utterly meaningless", but what he really wants to say is "academic" or revising upwards, "academically challenging"...and I must say that Stephen warns us ahead of time:

"But we have now left the world in which [the rule] is useful: CPI inflation is around 2%, there are deflationary pressures - but the Bank cannot reduce interest rates much further."

So it is bravely onward with:

"A good place to start is the notion of the 'sacrifice ratio': the cumulative loss in output required to reduce trend inflation by one percentage point."

Leading the BoCanada to prepare to intervene:

"Last fall, it sought and obtained the necessary authority for purchasing a broad range of assets, and it has signaled its intention to undertake quantitative easing if when inflation drifts below the 2% target."

Do I comprehend Chart 7 which shows that in Canada, this recession is not so bad as previous ones atleast in terms of Output Gaps? I take it that "t" represents the start of the recession which is 4? months old...anso that nice upward sloping component of "Current Cycle" is...projection?

Following, slightly better I think, westslope, and reminded of the US/Can$ currency move ~Dec 07 (and wondering how much more prominent the entire fx theater is now...esp with tiny BoCan compared to interventions by BoJ up to 03?), I find it hard to believe that US deflation is not exported to Canada.
Has not been and will not be.
How does the "core" inflation calculation go wrt oil prices? [Does it matter that oil is a key export? Leaving it out of the calculation altogether presents a distorted picture of the economy --there would be no difference between Alberta's core inflation and Prince Edward Island's...but I bet you can feel the difference, yes?] wrt house prices? wrt tourism?
Ok, Stephen thanks for making me think.

"This rule has served us very well: inflation has been low and stable since the early 1990's."

I would argue that the 2% rule was too low - our recovery was much slower than that of the US in the early 90s - and our recession had started earlier and was much deeper because of the insanity of John Crow targetting 0% inflation.

Part of the problem is that with only 2% inflation, you are risking that some sectors will have to go into deflation to offset any sectors that are well above 2% inflation, and secondly, you are giving the CPI more validity than it deserves - because people can substitute goods when inflation affects one more than another (pork instead of chicken, or vice versa, steel studs in construction instead of wood, etc.), and thirldy, the CPI basket itself might not be 100% accurate in terms of changing tastes and accurately reflecting the underlying trends

Quick response to David:

You can't set negative interest rates and here's a quick explanation why:

the lender would never lend :
Would you lean 20$ to someone if he promised to give you 10$ back NEXT YEAR?
You wouldnt lend, because you'd be better off just stashing your 20$ under your mattress instead of waiting it out?

And of course, yes it would trigger an infinite *demand* for loans. If you offered me to take 20$ today and refund you 10$ next year, i'd take it even if deflationnary pressures means that this 10$ will be worth 1 000 000$ in today's money. I'd simply take the 20$, stash the 10$ I need to refund next year and do whatever I feel with the free "extra" 10$

Thanks Simon, that makes sense :)

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