The Bank of Canada's Next Steps

Michael Gregory, BMO Capital Markets, Toronto.
This article appeared in the March 2009 issue of Current Economics with permission of the author.

Key Concepts: Monetary Policy | Quantitative Easing | Credit Easing |
Key Economies: Canada |

The Bank of Canada cut its policy rate 50 basis points to 0.50% at the beginning of March, stating that “given the low level of the target for the overnight rate, the Bank is refining the approach it would take to provide additional monetary stimulus, if required, through credit and quantitative easing”. We’ll get the details on how the Bank plans to follow the Federal Reserve, Bank of Japan and Bank of England into the realm of credit and quantitative easing in the Monetary Policy Report due April 23 (Chart 1). Below, we discuss some potential next policy steps.

The Bank of Canada (like most central banks) reduces its policy rate to lower borrowing costs and stimulate the demand for credit. One can think of the typical borrowing cost as being composed of the policy rate plus term and credit premiums. As such, changes in the policy rate have the greatest influence on shorter-maturity borrowing costs (because the term premiums are the smallest) and on Government of Canada yields (because the credit premiums are the smallest). However, if the policy rate reaches its lower bound, and a central bank still judges that lower borrowing costs are warranted, term and credit premiums must be influenced directly while ensuring that lenders have sufficient liquidity and capital. This is the essence of credit and quantitative easing.

Quantitative easing has historically focused on the creation of bank reserves (which are central bank liabilities and part of the money supply), and without much fuss about the assets amassed on the other side of the ledger. However, the global credit crisis is forcing central banks to focus on the asset side, which is giving rise to what Fed Chairman Bernanke was first to refer to as “credit easing”. For example, to address distortions in term and credit premiums, the Fed is buying mortgage-backed securities to lower long-term mortgage rates. And, to circumvent parts of the credit creation process rendered dysfunctional by the crisis, the Fed started up its Term Asset-backed Securities Loan Facility (TALF) recently. Since some credit-easing efforts can cause net increases in reserves, the distinction between credit and quantitative easing gets blurred. For example, in the same week, the Bank of England announced a new £75 billion asset purchase program to be financed by the issuance of reserves. Whether we call this credit easing (CE) or quantitative easing (QE), the key thing is that they’re now going hand-in-hand.

We judge the Bank of Canada’s foray into credit and quantitative easing will likely focus on the availability of credit. The financing constraints of non-bank lenders and the balance sheet constraints of banks are still modestly encumbering credit creation. Meantime, existing measures such as the Bank’s $35 billion liquidity facility and the federal government’s $125 billion Insured Mortgage Purchase Program (IMPP) are doing admirable jobs in narrowing some credit spreads, while the recently announced inclusion of corporate bonds in the Bank’s liquidity facility for institutional investors should nudge other spreads narrower. But, the Bank might not be finished easing the old fashioned way.

Chart 1. Lower Bound
Policy Interest Rates (percent)
Chart 2. Historic Low Policy Rates
Canada (percent)
Policy interest rates around the world Canada's historic policy interest rates
   

Next step #1: Cut the policy rate, one last time, and re-commit to keeping it low… The Bank of Canada’s announcement also stated that “the target for the overnight rate can be expected to remain at this level [0.50%] or lower at least until there are clear signs that excess supply in the economy is being taken up”. The “or lower” reference is the eye catcher, but the Bank has only 25 basis points of rate cut room left before having to change its practice of setting a 25-basis point operating band around the target [the Bank of Canada charges +25 basis points for loans (a.k.a., the Bank Rate, Chart 2) and pays -25 basis points for deposits]. The symmetry is designed to encourage financial institutions to loan settlement balances (reserves) to each other and ensure the actual average overnight rate hovers close to its midpoint target (which it almost always does). Once the policy rate slips below 0.25%, this symmetry will be lost unless the Bank opts to narrow the band.

Furthermore, there is a limit to how low the policy rate can go before becoming problematic for the functioning of money markets. Short-term interbank lending lies at the heart of the money market, and banks incur costs in participating (e.g., labour, computers, etc.). If rates fall too close to zero, costs might not get covered, and market participation could ebb. The same holds true for money market mutual funds. The lower bound for policy rates varies from country to country, depending on the characteristics of the local money market. For the US, it’s in the 0% to 0.25% range; Japan is 0.10% and the UK appears to be at 0.50% (where they cut to at the latest meeting). For Canada, we suspect it’s similar to the US, in the 0% to 0.25% range.

Chart 3. A Tale of Two Balance Sheets
Total Assets
Bank of Canada and US Fed balance sheets
   

Next step #2: Expand existing liquidity facilities… The Bank of Canada is currently operating three different liquidity facilities. The Term Purchase and Resale Agreement (Term PRA) Facility allows primary dealers and large financial institutions to raise funds via repos of eligible securities for up to three months. There is currently $35.4 billion outstanding. The Term Loan Facility (TLF) allows large financial institutions to use their non-mortgage loans as collateral for funds for one month, but it’s currently unsubscribed. The Term PRA Facility for Private Sector Instruments allows eligible institutional investors to also raise funds via repos of eligible securities, but it too is currently unsubscribed. Changes announced last month that will shortly come into effect (up to a 3 month maturity instead of 2 weeks, lower repo cost, inclusion of corporate bonds in eligible securities) are expected to ramp up the use of this latter facility.

While these three facilities can be tweaked with respect to size, frequency of offerings, cost to borrowers and eligible collateral, they remain short-term liquidity facilities. If converted to longer-term facilities, they could become significant forces of credit easing. In particular, the TLF could fill the void between 3-month-and-under-funding (via Term PRA) and 5-year funding (via the IMPP). As lenders get access to assured funding over longer time frames, they are more likely to make loans in the first place, and over longer terms.

Chart 4. Paper in Pieces
Canada (C$ blns outstanding)
Commercial paper in Canada
   

Interestingly, although the size of the Bank of Canada’s balance sheet has soared owing to the surge in term PRAs, primary dealers and large financial institutions have used the proceeds to purchase t-bills and t-bonds, essentially replacing riskier securities in their portfolios (Chart 3). Importantly, the funds have flowed back into the government’s coffers at the central bank. This means that there has been little money supply creation from Term PRA. This stands in stark contrast to the Fed’s inflated balance sheet which has seen bank reserves skyrocket.

Next step # 3: Participate directly in the asset-backed commercial paper (ABCP) market…
One of the key consequences of the global credit crisis for Canada has been reduced investor demand for corporate paper, generally, and asset-backed commercial paper, specifically (Chart 4). For non-depository lending institutions that funded their activities by issuing paper in their own names or by selling their loans to ABCP-issuing conduits, their lending activities became and remain impaired. This has impacted automakers’ financing arms, monoline and retailer credit card issuers, other sales finance operations and the nation’s tiny subprime mortgage segment. It has also affected bank lending to the extent that balance sheets are now a more binding constraint because it’s more problematic to take loans off balance sheet. Meantime, more bank balance sheet room has been absorbed by CP-issuers backing into their bank credit lines and the support provided to sponsored ABCP programs.

Reinvigorating the ABCP market would go a long way in alleviating the largest credit creation encumbrance in Canada, caused by the global credit crisis. One option would be a TALF-like facility to fund private purchases of ABCP, backstopped by the federal government. Ottawa has already introduced a $12 billion Canadian Secured Credit Facility to support the term asset-backed securities market (specifically for vehicle and equipment loans and leases), to be administered by the federal agency, Business Development Bank of Canada.

Bottom line: The Bank of Canada is currently crafting its credit and quantitative easing playbook. However, the world-class soundness of Canada’s chartered banking system has proved to be an invaluable (and much envied) antidote to the worst effects of the global credit crisis. Indeed, despite this crisis, household and business credit has continued to expand, albeit more slowly. As such, the Bank of Canada’s CE/QE manoeuvres might look minor in the company of the Fed, Bank of Japan and Bank of England. Nevertheless, we suspect the Bank will also be crafting a Plan B, to remain under cover for the time being and to be used in the event deflation risks become too high. This could involve such extreme measures as the monetization of government debt (Canada is one of the few countries with hefty fiscal capacity) or buying corporate bonds. We now await April’s Monetary Policy Report.

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