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April 22, 2020

The Bank of Canada’s rate announcement last week — no change — was no surprise. But the effects of its asset purchases could be. The Bank had already lowered the target rate to its effective lower bound of 0.25 per cent, so a further cut was not expected. The Bank didn’t say so but the rate may stay where it is for a while.

The Bank did discuss expansions to quantitative easing (QE), however. How QE will play out for monetary policy, and especially the inflation target, is cause for concern. In its Monetary Policy Report and subsequent press conference, the Bank emphasized that its actions to date have been oriented towards supporting the smooth functioning of financial and credit markets. A focus on financial stability at a time like this makes sense. But it is also worth thinking about the medium-term consequences for inflation and how that might impact the economy.

The exact design of the wide array of emergency facilities the Bank has set up in recent weeks is open to debate. The sheer size of these facilities is not. It is a fact — and unprecedented. In less than a month (March 11 to April 8), the Bank’s balance sheet more than doubled — from $120 billion to $275 billion. By contrast, its largest one-month increase in 2008 was a mere 20 per cent. Even the Fed didn’t move that fast or that much, either in 2008 or during this pandemic, for that matter.

Most of the increase was in so-called high-powered money: currency in circulation plus deposits held at the Bank of Canada by financial institutions (their “reserves”). This expanded from slightly more than $89 billion on March 11 to almost $227 billion on April 8. The financial institutions’ deposits ballooned from just $250 million (with an “m”) to over $134 billion (with a “b”), a direct consequence of the Bank’s asset purchases. In 2008, they increased from $25 million to $3 billion, which looks extremely modest compared to what is happening now.

In the short run, Canadian financial institutions are not generally using this massive increase in their reserves to expand lending, which would lead to a commensurate increase in inflation. Should this change, however, such a huge increase in the money supply will eventually be highly inflationary, with more money chasing after a limited supply of goods.

The Bank will be faced with hard choices about how to avoid the inflationary consequences of its actions. What are its options?

One possibility would be to make clear the expansion of its balance sheet is temporary, as it was in 2008. But announcing a path for the balance sheet will rob monetary policy of its power to boost demand. If households and businesses know all the money will soon be taken away, they will adjust their spending and saving accordingly. On the other hand, central banks often have trouble shrinking their balance sheets after engaging in QE. The Fed’s balance sheet was just $1 trillion before the financial crisis but sat at $4 trillion before COVID-19 began.

A second possibility would be to maintain what is now effectively a “floor” system for the overnight interest rate. In normal times, the Bank operates a “corridor” system that encourages financial institutions to lend to each other at the target overnight rate. The “encouragement” is that if they wish to borrow from the Bank, they pay 25 basis points above the target, while if they leave reserves on deposit with the Bank, the interest on those reserves is 25 basis points below the target.

In exceptional times, such as today, the Bank of Canada operates a floor system in which the interest banks get on their deposits with the Bank is the overnight rate target itself. So there’s no interest gain from lending funds to other banks rather than leaving them with the Bank of Canada. Higher deposits at the Bank usually means less lending to the economy. That does mute economic activity somewhat but the silver lining is slightly less inflation.

Finally, the Bank could do what it normally does when inflation bubbles up: increase the overnight target rate, which will push up interest rates generally. Unfortunately, that will raise the carrying cost of all the new debt our governments are taking on as they try to fight the COVID slowdown. If interest rates rise above the rate of economic growth, servicing the debt becomes unsustainable without either a reduction in government spending or an increase in taxes. The alternative, keeping rates low, could lead to a situation similar to a famous episode in the U.S. in 1951 when the Fed continued buying Treasury bills at ultra-low rates even as inflation was skyrocketing. This untenable situation led to an accord between the Fed and the Treasury, allowing the Fed to focus on fighting inflation instead of financing U.S. war debt, which had been a preoccupation in the immediate postwar years.

Each option will have different consequences for both the prices Canadians face and the prices they expect to face. Transparency on the part of the Bank of Canada will be crucial in order to align expectations with reality.

Published in the Financial Post 

Jeremy M. Kronick is associate director, research, at the C.D. Howe Institute, where Steve Ambler is David Dodge Chair in Monetary Policy. He is also a professor of economics at Université du Québec à Montréal.