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June 4, 2020

Even before the Bank of Canada’s interest rate announcement on Wednesday, the eyes of monetary policy watchers had shifted elsewhere – to the bank’s expanding balance sheet.

There was little surprise when the central bank left its target for the overnight rate at 25 basis points, with the deposit rate paid to banks also remaining at 25 basis points.

In fact, the target overnight rate is expected to remain where it is – a level at which the bank considers further cuts to be counterproductive – until at least well into 2021.

It is clear that the overnight rate will not be the centrepiece of the bank’s monetary policy for the foreseeable future.

Instead, the bank’s balance sheet and how it stickhandles it will play the starring role in achieving the bank’s monetary policy objectives. And, while the immediate needs of the COVID-19 crisis have meant a focus on financial stability and ensuring functioning credit markets, as the recovery gets under way, the balance sheet will also be instrumental in the bank’s ultimate objective: hitting the 2-per-cent inflation target.

The bank’s announcement acknowledged the need to deal with both financial stability and inflation simultaneously as we look ahead, by stating that “The bank maintains its commitment to continue large-scale asset purchases until the economic recovery is well under way. Any further policy actions would be calibrated to provide the necessary degree of monetary policy accommodation required to achieve the inflation target.”

First, let’s consider the balance sheet as a tool for financial stability. What the bank terms “large-scale asset purchases” is more popularly termed quantitative easing, or QE. These purchases inject money, or stimulus, into an ailing economy and have a direct impact on the size of the bank’s balance sheet, which has nearly quadrupled from $120-billion the week of March 11, to nearly $465-billion the week of May 27. The bank’s asset purchases, both traditional federal government debt and non-traditional provincial and private-sector debt, have ensured the smooth functioning of financial markets. It would appear the bank’s strategy has largely succeeded, with borrowing costs on federal and provincial debt coming down after huge spikes and measures of liquidity in these and private markets returning to much more stable levels.

During the shutdown the concern has been likely more on deflation than inflation as, with most businesses closed and people at home, there was very little demand. Therefore, the expansion of the balance sheet was able to deal with financial stability concerns, while simultaneously not threatening the usual inflationary pressures.

However, as the economy starts to recover, this balancing game will prove more difficult. With so much uncertainty, the bank’s use of the balance sheet must achieve three things at the same time: boost demand to aid in the recovery; prevent inflation and inflation expectations from falling significantly below the 2-per-cent target in the short run; and ensure that inflation rises to the bank’s 2-per-cent target over the medium run once the recovery is under way.

A few things for the bank to consider:

First, the precariousness of the recovery means the bank should not reduce its expanded balance sheet with undue haste. There is ample evidence that QE will boost private-sector spending only to the extent that it is expected to remain in place over a longer period of time. Households, businesses and markets get jittery if they think the expansion will be quickly reversed. We have seen the failure of other central banks to generate robust recoveries because they shrank their balance sheets too soon.

Second, there are implications for continuing to leave the deposit rate paid to banks equal to the overnight target rate. Doing so means banks earn the same interest leaving excess reserves at the Bank of Canada as they do lending to each other. As a result, the opportunity cost to banks of holding reserves on deposit with the Bank of Canada is lower, and this may reduce incentives for banks to expand lending. This contributed to lower-than-expected inflation after the financial crisis, and will be an important part of ensuring inflation – and inflation expectations – return during the recovery.

Third, allowing a period further down the road during which inflation exceeds the 2-per-cent target (but remains within the acceptable 1- to 3-per-cent band) might offset the period of lower-than-target inflation that began with the onset of the pandemic and which will likely continue for some time after the period of forced lockdowns ends. This will also help anchor inflation expectations, and allow the bank to hit its 2-per-cent target over the more medium run.

Achieving these objectives will require a major balancing act by the bank. They have shown immense flexibility so far. More will be needed. A move from the overnight rate to the balance sheet as the primary monetary policy tool is a big change. Clarity and transparency, as always, will be key.

Published in the Globe and Mail

Jeremy Kronick is associate director, research, at the C.D. Howe Institute. Steve Ambler is the David Dodge Chair in Monetary Policy at the C.D. Howe Institute and a professor of economics (retired) at the École des sciences de la gestion, University of Quebec at Montreal.