Why has the Bank of Canada "done nothing" for 4 years?

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.

4. Credibility.

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.

Comments

[Jciconsult]

Your perspective on forward commitment is probably correct. However, is part of the answer that the costs of fine-tuning the policy rate higher than the gain on stability in a low/no growth environment? Some would argue that we have paid a price in terms of a higher exchange rate with a policy of keeping the policy rate at 1% rather than crashing it to 0.25% or less in response to our meager performance. However, other pessimists might argue that leaving it stable left room to maneuver if things really got worse which is potentially likely. IMHO rule-based tinkering with the rate would have added costly volatility to the policy environment and used up the bank's powder with little gain.

[Nick Rowe]

Jci: Hmmm. I think I follow you. I think you might be right, that the variance in short term interest rates, or the exchange rate, might be lower using some sorts of forward commitment. Certainly, for example, if the Bank always used one-period-ahead forward commitment, people would always have at least 6 weeks warning of any change in the overnight rate.

But that raises the question: if that short term predictability of short rates is so important, why didn't the Bank of Canada *always* do monetary policy this way?

Maybe it just changed its mind. Or maybe the benefits of short-term predictability of short rates has been higher in the past 4 years than it had been previously?

[wh10]

7. Why does the central bank keep this a mystery?

[Nick Rowe]

wh10: Good question. Dunno. Maybe because, like the rest of us, it just makes decisions one-by-one, according to circumstances, and isn't fully self-aware. Plus, there may be some strategic ambiguity in the concept of "forward guidance", which is somewhere on the fuzzy line between a prediction and a promise. Sort of a soft promise, that it will break if it really needs to. Maybe it is scared of financial instability, and doesn't want to be too clear in case financial markets get overconfident. Maybe it doesn't want to come right out and say that it raised the overnight rate too much too soon, and lowering it again would be too blatant an admission of that mistake.

Or maybe I'm just wrong, and it really was just a fluke.

[Jacques René Giguère]

Credibility?
In your Mazda, what is more credible and reassuring to your passengers? A commitment to stay the course come what may or a promise to veer if a truck come in your lane?
As a prophet once said:"When facts change, I change my mind.And you sir?"

[CMA]

"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?"

Maybe because interest rate targeting isn't very effective.

[Tom Brown]

"Maybe it has been actively managing monetary policy by varying the length of its commitment to do nothing."

This caught my attention: I'm going to remember that line if I ever get a job in management, and I have to explain why I was sleeping at my desk.

[Max]

Suppose the central bank interest rate committee went on permanent vacation, but nobody knew it; everyone believes that the central bank is doing a great job. How long could the economy cruise along before things went haywire?

[Squeeky Wheel]

Maybe Canada has a one percent lower bound - the one percent refuse to let the bank keep rates below one percent for a long period. It has the benefit of sounding nice and pleasing BIS :)

[Hugo André]

Perhaps the CB believes that the active fiscal policy seen during the last few years has been enough to more or less balance demand. If the government has ready-to-go projects that it can implement, it will be able to affect AD quicker than a CB rate change would.
I'm not saying I approve of this but surely it's a possibility.

The idea put forward by Sqeeky Wheel is also quite convincing however. It may be that the active fiscal policy has given the CB an excuse to not do anything controversial (like setting "ultra-low" interest rates).

[jt]

JP Koning had a related piece ...
http://jpkoning.blogspot.com/2013/09/woodfords-forward-guidance-vs-forward.html

Maybe the simple answer is Canucks are sheepish; they respond to the threat of Chuck Norris, and you don't really need to bring in Bruce Lee.

[Nick Rowe]

Hugo: I can imagine a world where that is possible, but it's not Canada over the last 4 years. That would require a very activist "fine-tuning" fiscal policy, with frequently announced changes in response to the latest data. And we just haven't seen that. There was a fiscal policy response to the recession, but it was much too "coarse-tuning" low frequency to explain the last 4 years. They increased spending at the beginning, then steadily reduced it again. But those reductions were announced well in advance.

Squeeky: the best cure for low interest rates is low interest rates. With the benefit of hindsight, if the Bank had waited a bit longer before raising rates to 1%, it could have raised them above 1% sooner, because the recovery would have been quicker. It looks more like a reluctance to cut interest rates after having raised them, rather than a reluctance to have low interest rates.

Max: that's a question I have been asking myself. After 20 years of targeting 2% inflation, the Bank has built up a lot of credibility, and people expect roughly 2% inflation regardless of anything the Bank does today, so inflation stays at roughly 2%. Inflation becomes inertial at around 2%. But again, that credibility isn't something that suddenly appeared in the last 4 years. And the Bank wants to retain its credibility.

CMA: if interest rate targeting wasn't very effective, then forward commitment on interest rates wouldn't be very effective either.

Jacques Rene: but the facts (presumably) have been changing over the last 4 years. Why hasn't the Bank been changing its mind on what overnight rate is needed to keep future inflation at 2%?

We can argue about whether 2% inflation is the best thing to target, but that is what the Bank says it is doing. And even if it were secretly doing something else, why wouldn't it adjust the overnight rate in response to changes in information, so it could hit that something else target?

[Nick Rowe]

jt: Chuck Norris is more of a threat strategy: "If you don't do Y then I will do X". And we certainly see Chuck at work in Canada. For example, the Bank of Canada doesn't really do anything to keep the overnight rate very close to the 1% target; it just threatens to do something if the overnight rate wanders away from the target. That threat is usually enough.

But, more generally, yes, as I said to Max. The 2% inflation target is very credible, and expected inflation doesn't move much from 2%, whatever happens. And that credibility is (more than) half the battle of keeping inflation at 2%, so the Bank needs to do less than if it weren't credible. It's more than half Chuck Norris. But if shocks do hit, and the Bank does nothing, inflation will wander a bit away from 2%, and Chuck eventually loses his power if he continues to do nothing, and loses credibility.

[Jacques René Giguère]

Nick: and what if it was to speed with which you change the rate and not the rate itself that is now the operative variable?
Years ago, I had a computer with both a joystick (you change the position of the mouse to change the position of the cursor) and a now-discontinued Felix (the changing position changed the speed of the moving cursor).
Just the thoughts of a humble IO guy here to learn...

[Min]

"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"

That's my guess. The theory is wrong. Or perhaps more accurately, the theory is incomplete.

I am bold enough to make that statement without knowing the theory. Why? Because of my study of human systems in general. If there is a theory that predicts runaway feedback in a human system, it is almost certainly wrong. Human systems are surprisingly durable. Sometimes they fall apart from positive feedback, but that is rare. Why they do not is seldom apparent. If it were, the theories would be different. So I expect that positive feedback theories are wrong for unknown reasons. ;)

[JP Koning]

Interesting observation, Nick.

"Maybe it is scared of financial instability..."

I agree with that. I think that rightly or wrongly the powers that be have been substituting BoC rate changes with CMHC mortgage policy changes... thus the relative rarity of BoC rate changes whereas we've had one or two major CMHC mortgage underwriting changes each year.

[Jon]

Mode 1: Use interest rates as the instrument. This is a relatively passive policy because the overnight rate iof canadian banks is a minor unimportant rate except when it is way too high and leads the banking system to Hoover up deposits. Normally policy is actually passive and set by the US. Forex flows keep the interest rate neutral, therefore inflation stays credibly on track.

Mode 2: decouple the cad and usd by staging a forex intervention. E.g. Express concern cad is too strong creating a one sided limit, suddenly the policy rate bites and stimulates the economy but only given a credible commitment by the CB to decouple real rates by acting directly in the forex market.

[Gregor Bush]

Nick,

Are there different implications for CAD, and therefore the composition of growth, from tightening/easing policy via forward commitment versus the old fashioned way? Surely CAD responds to both surprise changes in the overnight rate and surprises changes in forward guidance. But it seems to me that the impact on the spot FX rate might be more powerful with the former than with the latter because with the former the central bank alters the carry on the currency but with the latter it doesn’t. Could it be that the underperformance of Canadian exports that Poloz keeps highlighting is at least partly a result of the Bank switching from one type of policy instrument to the other?

[Nick Rowe]

Jacques Rene: "Nick: and what if it was [the] speed with which you change the rate and not the rate itself that is now the operative variable?"

In Old Keynesian models, the level of demand depends on the level of the interest rate. In New Keynesian models it's a bit more complicated. An unexpected change in the level of rates causes a change in both the level of demand and a change in the growth rate of demand in the opposite direction. But even so, the economy didn't suddenly switch from being Old Keynesian to New Keynesian 4 years ago.

Min: "If there is a theory that predicts runaway feedback in a human system, it is almost certainly wrong. Human systems are surprisingly durable."

I tend to agree. Any system that allows for runaway feedback probably exploded centuries ago, so is unlikely to be observed today. Survivorship bias.

In the olden days, the tie to gold (or silver, for Lorenzo) prevented runaway feedback, except when that tie was broken. When we all went off gold, we started to see the beginnings of runaway feedback in the 70's, until central banks recognised the problem and adjusted rates in response, stopping the runaway feedback. But maybe 4 years is just too short a time to see anything much.

JP: thanks. OK, there have been those changes to CMHC rules. And they were maybe not planned in advance, but did respond to the state of the housing market. So you could say they were sort of like countercyclical fiscal policy. But is the housing market a good enough proxy for targeting 2% inflation?

Jon: but the BoC does not directly intervene in the forex market. And the Party Line is that the overnight rate is "trend-setting" for all other interest rates. (I say this is because the BoC is the alpha bank, due to asymmetric redeemability.)

Gregor. I think there must be implications for the exchange rate. Because anything that affects the term structure will also affect the exchange rate. My brain isn't up to the job of figuring out exactly what those effects are, but my guess is they won't be very big, or last very long. Very small changes in the exchange rate would preserve interest rate parity for a small twist in the short end of the term structure.

[Jon]

Yes boc is the alpha bank but regulatory constraints on banks mean they don't deal in most debt instruments. Take the US case? The fed has basically pushed nonbank lenders out of the MBS and long term treasuries. Sure there is still a bit of rope left but the residual is small so they cannot transmit their low rates further.

Think about the process of dynamic adjustment with respect to the nominal stock of debt and the elasticities of each instrument.

[Richard Besserer]

Don't forget that Canada is a small open economy. To a great degree the BOC's hands are tied by the Fed's remaining at the zero lower bound. Tightening much faster than the Fed would result in a further, not necessarily desirable rise in an already high real exchange rate.

Not to put too fine a point on it, Canada has been stuck at one percent for so long because the Fed has been stuck at zero. Don't expect much tightening from the BOC before the Fed tightens---and that day seems as far off as ever.

[Nathan W]

In such times, I would argue that persisting in doing nothing when it is the best policy approach is a sign of great strength on the part of these decision makers, and moreover is a testament to the independence of the central bank, an requisite feature of a good institutional environment for good monetary policy.

I think they are committed to increasing the interest rate just as soon as inflation heats up. They always anticipate that this will be not too long from now and so imply that the next small rise in interest rates will be soon.

Then, every time, they look at the picture and say "not yet".

I'm not sure I would consider this as a policy of forward commitment, per se, but rather that they routinely renew a technical commitment to inflation targets, then continue to do nothing.

If it weren't for housing prices and their continued rise in the face of all other economic realities (why? who knows ...), my guess is that they would have lowered interest rates a bit again because inflation (when excluding all those volatile components which are unavoidable expenditures that we could never put off even under deflationary situations (food, fuel, etc.)) is still very low. And as for this last bit - there's a good reason for the central bank to use this measure of inflation for technical reasons, but truly it means that "core inflation" is not a very useful measure for costs which actually matter to people, especially when fuel and food are a relatively high shares of expenditures.

[Lorenzo from Oz]

After setting the bank rate at 5% in April 1719, the Bank of England did not change it again until June 1822. But I have taken than to be an indication of how much the "Bank of England bank bargain" suppressed the English credit market since the BoE had no obligation for any sort of macroeconomic stability. So, an historical whimsy point, really.
http://www.bankofengland.co.uk/statistics/Documents/rates/baserate.pdf

The RBA has been somewhat more active in its cash rate than the BoC. It has not shifted it since August last year, but it shifted it 4 times in the previous year (only by 25 points each time), 4 times in the previous year (3 times 25 points, once 50 points), only once in the previous year (by 25 points: the only increase). So, from August 2010 to August 2014 it has gone from 4.5% to 2.5%. But since the RBA is all about managing inflation as an average over the business cycle (i.e. in an anti-cyclical way) in a somewhat two-speed economy, perhaps it has a more difficult task than the BoC.
http://www.rba.gov.au/statistics/cash-rate/index.html

So, I have no explanation except that perhaps there is indeed considerable inertia and for 4 years nothing happened that threatened the inertia beyond what could be covered by forward guidance.

[Nick Rowe]

Lorenzo: The Bank of England (I think) was on the gold standard during that period. So it was buying and selling gold, to stabilise the price of gold. And, my guess is, the BoE would not be offering to borrow and lend unlimited amounts at that fixed Bank Rate of 5%. So that market interest rates could fluctuate with gold market operations despite the fixed Bank rate.

But I wish I understood monetary history better.

Thanks for that useful comment.

[Senator-Elect]

Thank you for addressing this issue, Professor Rowe.

However, I'm not convinced by your explanation and I wonder why the Bank has not taken more or different actions. For example, why has it not, to my knowledge, publicly called for federal fiscal policy to be looser? I wonder if it has done so privately, at least.

A different way of putting the question is to ask whether the Bank has fulfilled its mandate over the past four years. If not, why not?

[Nick Rowe]

Senator: I confess I'm not convinced by my explanation either!

I don't see why the BoC should want fiscal policy to be looser. If it had wanted to increase aggregate demand, because it feared that inflation was going to fall below target, it could have loosened monetary policy instead.

The Bank's mandate is to target 2% inflation. On average, it has hit that 2% target almost spot on. But at times it has missed, sometimes on the upside, and sometimes on the downside. Since the BoC doesn't have a crystal ball, and can't perfectly forecast inflation, some misses will be inevitable. It is hard to prove that the Bank didn't do the best it could, given the information available at the time, to hit the 2% target over the last 4 years.

[Lorenzo from Oz]

Actually, the BoE was off the gold standard from February 1797 to May 1821. But it was always expected to go back on the gold standard, which it did, and at the previous rate, which it did.

Indeed, it went back on the gold standard at the same rate 6 years after the 1815 end of the war, just as Britain did again in 1925 (6 years after the Versailles Treaty, 1919). Unfortunately, doing so while engaging in the pro to-Industrial Revolution while unions are illegal (1821) is a bit different from doing so with very legal and powerful unions + unemployment insurance + strong upward pressure on the value of gold (1925) ... Hence the 1926 General Strike, constant balance of payments crises, etc.

But yes, buying and selling gold was an alternative option. Also, the English credit market was repressed, as the Bank of England "bargain" basically strongly inhibited competition (it was the only permitted incorporated bank in England, for example). So, one can presume other interest rates did fluctuate, but not in a way or scale that pressured the BoE.

[Nick Rowe]

Lorenzo: "Actually, the BoE was off the gold standard from February 1797 to May 1821. But it was always expected to go back on the gold standard, which it did, and at the previous rate, which it did."

AHA!!! That is really important. Suppose AD falls, and P falls. People then expect P eventually to rise, so expected inflation increases, so the real interest rate falls, so AD rises. That creates the automatic self-equilibration even when nominal interest rates are fixed. It prevents the price level spirally down and down (or up and up). It's sort of like price level targeting.

[Lorenzo from Oz]

And nothing weird was happening with gold, since only a few countries were on the gold standard, the silver or specie (bimetallism) standards were much more common.