Monetary policy in a period of financial chaos

Is zero-inflation and central bank independence still relevant?

Clinging to inflation targeting

• While the rest of the world is plunging into financial chaos and depression, the Bank of Canada still claims that:

• “Low, stable, and predictable inflation is the best contribution that monetary policy can make to the economic and the financial welfare of Canadians” (Monetary Policy Report, April 2009, p. 25; same sentence in Carney’s speech of 1st of April 2009).

• “Any unconventional action initiated by the Bank must have as its primary objective the achievement and maintenance of the Bank’s 2 per cent inflation target” (Deputy Governor Murray, May 2009)

The Bank can’t even predict future growth

Year 2006 2007 2008 2009

Semester I II I II I II I II

Realized rates 2.85 1.6 3.9 1.4 0.5 -0.7 -1.2

12 months ahead * 2.9 2.9 2.7 2.8 2.5 2.7 2.2

6 months ahead 2.9 3.2 2.5 2.6 2.1 1.8 0.4 0.7

Realized real GDP quarter-over quarter percentage change, averaged per semester, versus base-case projections of the Bank of Canada

The world was in turmoil in August and September 2007…

0

400

800

1200

1600

2000

7/30/07 8/06/07 8/13/07 8/20/07 8/27/07 9/03/07 9/10/07

Actual LVTS Settlement Balances

Millio

ns

$

Source: Bank of Canada, http://www.bank-banque-canada.ca/en/rates/interest-look.html

And also in the Fall of 2008 …

-500

0

500

1000

1500

2000

2500

3000

2008M09 2008M10

Actual LVTS Settlement Balances

Millio

ns

$

Source: Bank of Canada, http://www.bank-banque-canada.ca/en/rates/interest-look.html

While the Bank remained obsessed with inflation targeting

• Two weeks after the near-meltdown of interbank lending on August 13, 2007, Deputy Governor Duguay’s speech was about whether Canada should move to price level targeting (August 27)

• (also Deputy Governor Jenkins Oct 2007).• One year later, Deputy Governor Murray was

discussing how best to measure inflation (September 18, 2008).

• The latest issue of the Bank of Canada Review (21 May 2009) is entirely devoted to the issue of whether the inflation target should be lowered and whether the Bank should abandon inflation targeting in favour of price level targeting.

Lowering the inflation target: Milton Friedman born again

• The most abstract models conclude that the optimal inflation rate is negative (deflation) and equal to the growth rate of productivity.

• We are back to Friedman’s optimal theory of money, according to which the nominal interest rate ought to be zero, with the real rate equal to the growth rate of productivity.

0% inflation target now

• One major objection against lowering the inflation target is that there would be large unemployment costs during the transition period to the lower inflation rate.

• Clearly now would be the best time for the Bank of Canada to implement 0% inflation targeting or price level targeting, as the subprime crisis has already brought the inflation rate close to zero.

Price-level targeting

• Most studies seem to show that price-level targeting is preferable to inflation targeting.

• It reduces uncertainty about the future price level.

• This obsession with the stability of the price level is rather surprising given that Canada is on a pure flexible exchange rate regime, with the Canadian dollar having moved from US$0.80 to $1.10 and then back to $0.80, giving rise to great price uncertainty for exporters.

0% inflation and expansionary policy

• “The significance of the zero lower bound has increased significantly in the aftermath of the 2007 subprime-mortgage meltdown … Further research focusing specifically on the connections between the inflation target and the zero lower bound … should be a priority in the future” (Amano, Carter, Coletti, 2009).

• What? It was not really considered up to now?

Central bank independence is an illusion

• During the fight against the financial meltdown: • The balance sheet of the Bank of Canada

jumped up from $53 billion in August 2008 to $80 billion in March 2009;

• The total amount of Government of Canada securities outstanding jumped up from $402 billion in August 2008 to $497 billion in March 2009.

• This was before the government started accumulating deficits.

Central bank independence is an illusion

• “Just as the boundary between monetary stability and financial stability becomes increasingly blurred in the midst of a financial crisis, so too does the boundary between monetary and fiscal policy actions. It isn’t uncommon for both central bank and governments to initiate credit-easing measures, and it is important that the two work together” (Deputy Governor Murray, 19 May 2009).

Where did all these government securities go?

Bank assets

August 2008 March 2009

Mortgages 487 434

Corporate securities

168 116

T-bills 28 53

Canadian govt bonds

126 211

Total 1733 1787

Where did the mortgages go?

• They were purchased by the Canadian Mortgage and Housing Corporation (CMHC) to the tune of $51 billion as of March 2009, through the Insured Mortgage Purchase Program.

• $125 billion has been set aside for this (25 in September 2008, 50 in November 2008 and 50 in the January 2009 Budget)

• The program now seems to be stalling.

Banks CMHC

Assets Liabilities Assets Liabilities

Mortgages -$50 BGovt Securities +$50 B

Mortgages +$50 B

Loans from federal govt +$50$ B

Federal government

Assets Liabilities

Claims on CMHC +$50 B Securities +$50 B

How did CMHC acquire the mortgages? It got loans from the federal government

Bank of Canada balance sheet (in billions of dollars)

Assets 53.5 80.4 Liabilities

Aug 2008

March 2009

Aug 2008

March 2009

Bills 22.4 13.8 Notes 50.0 51.2

Bonds 30.8 31.5 Govt deposits

2.3 28.1

PRA 0.2 34.8 Bank reserves

0 0

There is (nearly) no increase in the monetary basePRA: Purchase and Resale Agreement

Three strategies to improve the liquidity of the balance sheet of banks.

• First, banks sold some of their mortgages to the CMHC, obtaining bonds.

• Second, the Bank of Canada granted 28-day purchase and resale agreements (PRA) backed by ABCP and less liquid securities (long-term federal, provincial), sterilizing these purchases by selling the T-bills that it held to banks.

• Third, the Bank granted 28-day purchase and resale agreements (PRA) backed by the same less liquid assets, sterilizing these purchases by first acquiring T-bills from the federal government, and then selling these T-bills to banks.

Table 5: Composition of the term purchase and resale agreements conducted by the Bank of Canada (in

billions of dollars)

2008

November December

Government of securities

16.0 20.7

Provincial securities 9.8 8.0

Municipal securities 0 0.1

Corporate securities 5.7 5.6

ABCP 2.9 3.2

Total 34.5 37.7

Evolution of Assets of Bank of Canada

0

10000

20000

30000

40000

2008M07 2008M10 2009M01 2009M04 2009M07

Repos and other assetsBondsAdvancesTreasury bills

Mill

ions

$

Source: Statistics Canada, CANSIM Series V36612, V36613, V36634, V36635, and V44201362.

Evolution of liabilities of Bank of Canada

0

10000

20000

30000

40000

50000

60000

2008M07 2008M10 2009M01 2009M04 2009M07

Government DepositsAll Other LiabilitiesNotes in CirculationBank Deposits (Reserves)

Mill

ions $

Source: Statistics Canada, CANSIM Series V36625, V36628, V36632, and V36636.

Impact of term PRA operations on LVTS balances when the size of the balance sheet of the Bank of Canada is rising

Banks Bank of

Assets Liabilities Assets Liabilities

Long securities -$30 BLVTS balances +$30 B

Term RPAs +$30 BLVTS balances -$30 B

T-bills +$30 B Government deposits +$30 B

T-bills +$30 BLVTS balances -$30 B

T-bills -$30 BLVTS balances +$30 B

Long-term securities -$30 B

T-bills +$30 B

Term RPAs +$30 B Government deposits +$30 B

The Bank of Canada claims that conventional monetary policy is now helpless

• The inflation rate is approaching negative territory and the overnight interest rate is nearly at zero, so that the real overnight rate can’t be negative anymore.

• The spreads between the overnight rate and market rates are much higher than they used to, so that the reduction in the overnight rate has not been as effective as if spreads had remained constant.

• Since 2007 QIII, loan officers have been tightening lending conditions, and still are.

Rising spreads

-.2

-.1

.0

.1

.2

.3

.4

.5

.6

.7

2005 2006 2007 2008

Spread Prime Corporate Paper (1 Month) and the Overnight RateSpread Prime Corporate Paper (3 Months) and the Overnight Rate

Evolution of Spread between Prime Corporate Paper Ratesand the Overnight Rate, Canada 2005-2009.

Source: Statistics Canada, CANSIM II, Series V122491, V122509, and V 39050.

Perc

enta

ge P

oin

ts

Tightening credit conditions

Source: Bank of Canada website, Senior Loan Officer Survey, 9 October 2009

The new framework at zero-interest rate policy (ZIRP)

1. Conditional promise to keep the target overnight rate where it is for more than a year

2. Set the deposit rate on bank balances at the target overnight rate

3. Quantitative easing (unsterilized operations)4. Credit easing (sterilized or unsterilized): the Bank

purchases certain private sector assets in certain credit markets). This is already done indirectly through the PRA program where collateral can be ABCP, and through the purchases of the CMHC. This could be done to reduce interest rates on private assets relative to safe government assets.

• By promising to keep the target interest rate at 0.25% for more than a year, the Bank hopes to lower medium-run rates.

• The Governor (6 May 2009) claims that as a result “interest rates across the maturity horizon of the commitment fell”.

• The promise is conditional because the Bank fears that if interest rates were fixed without any consideration of possible inflation pressures, this might lead instead to rising medium-term rates.

Conditional statements

Yields on Canadian government bills after promise to keep interest rates down

Source: Bank of Canada, 19 May 2009

Settlementbalances

Overnight rate

0 + (surplus)- (overdraft)

Target rate TR = 0.50

Bank rate = TR+25pts = 0.75

Rate on positive balances = TR-25pts = 0.25

The standard framework vs the new ZIRP framework

25

Settlementbalances

Overnight rate

0 + (surplus)- (overdraft)

Bank rate = TR+25pts = 0.50

Target rate = Rate on positive balances

= 0.25

The standard framework vs the new ZIRP framework

3000

But if things go wrong, there is no incentive to lend on the overnight market;Banks would rather deposit their excess funds at the Bank, at the same rate.

Settlementbalances

Overnight rate

0 + (surplus)- (overdraft)

Target rate TR = 0. 25

Bank rate = TR+12.5pts = 0. 375

Rate on positive balances = TR-12.5pts

= 0.125

An alternative? Shrink the band

25

Quantitative easing

• In a sense, between April 2009 and May 2010, we were in a kind of quantitative easing situation.

• Since 21 April 2009, settlement balances are set each day at $3 B by the central bank (banks have $3B reserves, instead of zero as before).

• The only difference is that, instead of the excess settlement balances being provided by moving around government deposits, quantitative easing would provide the excess balances through open market operations (or by purchasing private assets).

Conventional vs unconventional policies

• There is a lot of irony with the current situation. What is now called conventional monetary policy is a slightly modified version of the kind of policy implementation advocated since the late 1950s by heterodox and post-Keynesian economists. It has become conventional policy once more since the early 1990s, after the demise of monetarism in the mid 1980s.

• By contrast, unconventional monetary policy, in particular quantitative easing, is the kind of monetary policy implementation that can be found in nearly every neoclassical textbook and that central bank economists faked to pursue.

• Officials at the Bank of Canada are quite aware of this paradox, and are obviously uncomfortable with it, as the following statement shows.

Bank of Canada balance sheet (in billions of dollars)

Assets 80.4 75.3 Liabilities

March 2009

May 2009

March 2009

May 2009

Bills 13.8 13.1 Notes 51.2 52.0

Bonds 31.5 32.5 Govt deposits

28.1 19.1

PRA 34.8 29.4 Bank reserves

0 3.0

Misleading claims on behalf of quantitative easing

• “The expansion of the amount of settlement balances available to [banks] would encourage them to acquire assets or increase the supply of credit to households and businesses. This would increase the supply of deposits” (Bank of Canada, Monetary Policy Report, Annex, 23 April 2009).

• “[Quantitative easing injects] additional central bank reserves into the financial system, which deposit-taking institutions can use to generate additional loans” (Deputy Governor John Murray, May 2009)

Quantitative easing = mistaken textbook story

• “Although quantitative easing is now referred to as an unconventional monetary policy tool, the purchase of government securities is, in fact, the conventional textbook approach to monetary policy…. In practice, most central banks have chosen to conduct monetary policy by targeting the price of liquidity because the relationship between the amount of liquidity provided by the central bank and monetary aggregates on the one hand, and between monetary aggregates and aggregate demand and inflation on the other, are not very stable.” (Bank of Canada, Monetary Policy Report, Annex, 23 April 2009).

Quantitative easing = monetarism

• “All quantitative easing is, by definition, ‘unsterilized’. Although this is correctly viewed as unconventional, it closely resembles the way monetary policy is described in most undergraduate textbooks, and is broadly similar to how it was conducted in the heyday of monetarism” (Deputy Governor John Murray, May 2009).

Quantitative easing is useless

• It assumes that credit is supply-constrained.• It assumes that banks will grant more loans

because they have more settlement balances.• The only effect might be to lower interest rates

on some assets. Will this have an impact on lending rates or on the exchange rate?

• Experience with the Bank of Japan: “Given that the interest rate is zero, no policy measures are available to lift the inflation rate to positive territory… The Bank did not have the tools to achieve it” (BoJ arguments as assessed by Ito, 1994).

Rough evolution Oct. 2008-March 2009

Govt B of C Banks NBFI FGBE House’lds

T-Bills -100 -10 +110

Mortgages

-45 -30 +75

Deposits at B of C

+25 -25

Deposits at banks

-50 +20 +30

ABCP +30 -30

Bank loan +20 -20

PRA +35 -35

Claims +75 -75

Total 0 0 0 0 0 0

The inflation band and the present recession

• This is a real challenge for the Bank of Canada.

• We will see whether the Bank can truly control inflation rates.

• The officials at the Bank of Japan did not believe that inflation targeting was useful when the central bank was trying to raise the rate of price inflation (instead of reducing it).

Pushing on a string

• During times of deep recession, the monetary emperor has no clothes.

• Central banks can only act as a lender of last resort, stopping the meltdown.

• Central banks can only be a useful appendage to expansionary fiscal policy, with the latter doing the important work of reversing the downward trajectory of the private sector.