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October 8, 2020 – The Bank of Canada must handle three challenges simultaneously—providing economic stimulus, hitting inflation targets and managing its massively expanded balance sheet—all while dealing with associated credit and political risks, says a new report from the C.D. Howe Institute.

In “Canadian Monetary Policy in the Time of COVID-19,” authors Steve Ambler and Jeremy M. Kronick explore the challenges the Bank of Canada faces as it goes beyond conventional monetary policy with large-scale asset purchases, and provide guidance on how to address them.

In response to the pandemic, the Bank of Canada dropped the overnight rate, the key monetary policy rate, to 25 basis points, and expanded its balance sheet at an unprecedented pace. “With these interventions come challenges and risks, both in terms of hitting the Bank’s 2 percent inflation target and navigating a balance sheet with assets, namely provincial and private-sector securities, outside its usual holdings of federal government debt,” write the authors.

To continue providing stimulus, Ambler and Kronick suggest the Bank consider purchasing longer-term government bonds and private-sector securities directly from the private sector to pump money into the economy and encourage spending. The Bank should also continue to communicate how its balance sheet will evolve, while explaining the rationale for continued intervention.

In order to keep longer-term inflation expectations anchored at 2 percent, the authors call on the Bank to temporarily overshoot its target. “A concrete way to achieve this would be to move to target the average rate of inflation over a horizon of two or three years,” say the authors.  

Finally, the authors note that keeping interest rates artificially low to reduce debt service costs, which would be very much in the interest of debt-laden governments across Canada, could easily jeopardize the Bank’s credibility and independence. It also suppresses any market signals with respect to the riskiness of government debt, thereby distorting credit markets where federal government bond yields serve as a benchmark.

To minimize the credit and political risk associated with the Bank’s holding of provincial and private-sector debt outside its usual scope, Ambler and Kronick propose exchanging those assets for Government of Canada debt. The federal government could open a new account in the Public Accounts of Canada to hold these securities. The decision to buy up the assets would be the Bank’s, leaving the federal government in charge of managing the associated credit and political risk.

“It is imperative that governments clearly lay out a plan for bringing back fiscal anchors that were set aside during the pandemic, with a clear plan for achieving the optimal level for these anchors,” conclude Ambler and Kronick. It is also imperative for the Bank of Canada to re-commit, alongside the federal government, to hitting the 2 percent target as part of the 2021 inflation-control renewal.”

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For more information contact: Steve Ambler, David Dodge Chair in Monetary Policy and professor of economics (retired) at the Université du Québec à Montréal; Jeremy M. Kronick, Associate Director, Research, C.D. Howe Institute; or Nancy Schlömer, Communications Officer, C.D. Howe Institute, email: nschlomer@cdhowe.org.

The C.D. Howe Institute is an independent not-for-profit research institute whose mission is to raise living standards by fostering economically sound public policies. Widely considered to be Canada's most influential think tank, the Institute is a trusted source of essential policy intelligence, distinguished by research that is nonpartisan, evidence-based and subject to definitive expert review.