The Bank of Canada did not surprise last week on its target for the overnight interest rate, which remains at 25 basis points and is expected to stay there until the economy fully recovers from the pandemic recession, sometime in 2023, according to the bank’s projections.
The real intrigue in the bank’s regular announcements these days surrounds its purchases of Government of Canada debt, and what they mean for its relationship with the federal government. Wednesday’s announcement left these purchases unchanged at $4 billion per week. However, this announcement requires a deeper dive, coming as it does after the federal government’s fall economic statement laid down substantial deficits and no fiscal anchor on the horizon.
Let’s start with the assumption that the bank is correct and the economy doesn’t fully recover until 2023, meaning there is a sizable output gap (the difference between actual and potential output) for the next year or so. In addition to the nearly $400-billion deficit during fiscal 2020-21, the fall economic statement added spending that will require $200-$275 billion in financing over the next two fiscal years, which brings us to 2023. At the bank’s current rate of purchase — $4 billion a week — that would be more than enough to finance the entire deficit.
Of course, the bank can buy less, but the point is that it is buying up lots of government debt (it has already purchased $200-billion worth of Government of Canada bonds since the crisis started), and that makes people worry about “fiscal dominance” — a situation in which the government’s deficit and debt are financed by money creation, and monetary policy becomes devoted to financing the government debt rather than achieving inflation targets. Indeed, Governor Tiff Macklem has already been forced to defend the bank’s position, arguing repeatedly at a recent House Standing Committee on Finance meeting that the bank was not financing the government.
Is it? In our view, the answer is no, not yet. As Gov. Macklem also stressed at that hearing, the bank holds about one-third of the outstanding stock of federal government bonds, below the guidance from other central banks that the maximum central banks can hold is between 50 and 70 per cent. The Fed has established its own limit at 60 per cent.
But despite the bank’s ample wiggle room, the economics behind these purchases remains important. With the output gap still sizable as we recover from devastating economic lockdowns, inflation remains well below its two per cent target, and the bank’s asset purchases are necessary to eliminate that slack, by keeping yields low at all maturities and thus encourage spending. There certainly are dangers to suppressing market signals by artificially lowering yield curves at longer maturities. An upward-sloping yield curve — with higher long-term than short-term rates — is usually a good thing in that it signals that investors see inflation and a strong economy in the future. But, on balance, if the bank believes the benefits outweigh the costs in achieving its two per cent target, these purchases are appropriate.
The more interesting question is what will happen as the economy approaches full capacity and inflation nears two per cent. The concern with the lack of a binding fiscal anchor in the fall economic statement is that spending might continue even as the economy returns to potential, keeping deficits high, putting upward pressure on inflation, and making it more difficult for the government to find borrowers for its debt.
If Ottawa is forced to turn to the bank, that would mean the central bank would have conflicting priorities: keeping the government funded vs. fighting inflation. At the moment the only operative policy anchor in Canada is the Bank of Canada’s commitment to its two per cent inflation target. When inflation does return to target, the bank can and should ease off on buying government debt and begin normalizing interest rates. In a speech last week, Deputy Governor Paul Beaudry reassured Canadians that’s what the bank would do. But if a rise in interest rates increases the federal government’s debt servicing costs substantially, there could be political pressure for the bank to back off.
The bank’s commitment to the two per cent inflation target becomes all the more important as we head into 2021 and the scheduled renewal of its inflation-control agreement with the government towards the end of next year. Consultations are underway and there are sure to be calls to change the mandate. But, in addition to the successes of inflation targeting over the past 30 years, the target being the only anchor left in Ottawa makes staying the course that much more important. Committing to firm guidelines would give the federal government stronger incentives to define firm fiscal anchors of its own.
The bank enjoys a large degree of operational independence. For the sake of good monetary policy, that independence should continue, and should be seen to continue.
Steve Ambler, a professor of economics at the Université du Québec à Montréal, is the David Dodge Chair in Monetary Policy at the C.D. Howe Institute, where Jeremy Kronick is associate director of research.