Mortgage Logic

Central Banking Crisis

OTTAWA — Bank of Canada Governor Mark Carney’s options were quickly running out.

The economy was still in deep decline, interest rates were already at their lowest ever and he couldn't take them much lower without bumping up against zero.

Like many central bankers these days, he turned to unconventional means. But instead of fully embracing the controversial printing-money approaches of the United States and the European Union, the Bank of Canada took a different tack.

In April, the bank joined a small club of countries in laying out very clearly where it plans to take its key interest rate over the coming quarters. Mr. Carney said he will keep it right where it is - at 0.25 per cent - for more than year, as long as nothing major develops.

A "near-guarantee," as central bank watchers call it.

The plan: By publishing its previously secret plans for interest rates, the Bank of Canada is using time and near-promises to bolster confidence, anchor inflation expectations and calm volatile credit markets.

On the surface, the tool seems far more benign that the intrusive and unproven quantitative easing approaches of central banks in other countries.

But it's not a risk-free venture. If the public digests the central bank's message as a firm promise, a change in direction from the bank could provoke the very volatility it aims to mollify.

And the long-term commitment to rock-bottom rates may do little for confidence and growth if it's seen as an impotent weapon against a vicious global recession, recent research suggests

The interest rate commitments that Canada has embraced - along with Norway, Sweden and New Zealand - may not do much to help the central bank in keeping the economy on an even keel. And at worst, they could backfire if markets ignore the strings attached.

"The difficulty is the problem understanding conditionality," said Chuck Freedman, a former deputy governor at the Bank of Canada who is analyzing the issue for the International Monetary Fund. "It would take time for the financial markets to adjust. And you have to have a lot of training to understand the conditionality."

Mr. Freedman should know: He has firsthand experience.

It was the spring of 1998, and the Asian financial crisis had yet to show its full force. The Bank of Canada, in a fit of transparency, decided to tell the public what it intended to do with interest rates. It would hold them steady, the bank said clearly - but only if there were no further shocks to the economy.

That condition was quickly forgotten by markets, and they traded as if the bank had guaranteed no movement in rates for months to come. When the financial crisis hit home that summer and sent the Canadian dollar into a freefall, though, the central bank felt the need to defend it, raising rates by a full percentage point.

From the markets' point of view, a promise was broken, money was lost, and the Bank of Canada had led them astray.

"I remember a lot of complaints," Mr. Freedman recalled.

The Bank of Canada quickly stopped publicizing its interest rate intentions, and reverted to the old system of issuing strong hints that were vague enough they could be changed on a moment's notice.

A decade later, however, the "conditional commitment" has moved front and centre in the central bank's defence against the economic crisis.

Magnus Andersson, for one, is not convinced any of it makes much difference. The senior economist at the European Central Bank (ECB) examined how explicit communication of a central bank's interest rate intentions had affected monetary policy in Norway, Sweden and New Zealand (three of the four countries that have used this technique for at least a few years; the other country is the Czech Republic).

Mr. Andersson found that publication of an interest rate path often came hand in hand with low volatility in capital markets and well-entrenched expectations for inflation - but that those conditions existed even before the interest rate paths were published.

In New Zealand, the central bank's move did give it some influence over medium-term interest rates. But generally, "we see very little difference," Mr. Andersson said in a recent interview, stressing that his views are his own, not the ECB's.

At the same time, publication of interest rate intentions imposed a new burden on central banks, requiring them to focus more of the public's attention on the risks to its forecast. "You have more of a pedagogic problem," he said.

The Bank of Canada has recognized that problem.

In its most recent economic outlook, it had to include a page of intricate "fan charts" as well as a link to further information, in an attempt to quantify the uncertainty and complexity underpinning its interest rate commitment.

And because the bank published its interest rate intentions last month, in terms that stressed the commitment but played down the conditions, Mr. Carney has had to devote much time to explaining the conditions to the public.

But communicating the attached conditions is not an insurmountable obstacle, said Amund Holmsen, who is on leave from his position as director of the monetary policy department at Norway's central bank.

"Norway didn't have a problem convincing people it wasn't a guarantee," he said in a recent interview. "People understand that this is a contingent forecast."

Norway has benefited from such an approach, and Canada could as well, Mr. Holmsen said.

"It's a good thing that the Bank of Canada has been that explicit. Hopefully it does something for them," he said in an interview. "I think the experience of New Zealand, Sweden and Norway is encouraging in terms of making this framework work."

Publishing interest rate intentions offers central banks an added tool to steer the economy without the added risks that quantitative easing invites, Mr. Holmsen said.

Indeed, in conditions such as today's, publication of interest rate intentions serve to remind consumers that rates will be low for a limited time, and if they want to benefit from lower rates, they should do it soon, he said.

Still, the Bank of Canada has so far limited its commitment on interest rates to the next year, and has not said what it will do as that year draws to a close, Mr. Holmsen noted.

If the bank wants to diminish volatility further, it will have to say if its latest tool is a permanent part of monetary policy in Canada, and if so, how it will work over the long term.

From the Bank of Canada's point of view, the experiment has been a success so far, because it immediately cut the cost of longer-term borrowing after it was bolstered by central bank intervention in one-year securities.

"Canada has made the most explicit commitment of the major industrial countries and has backed its words with actions. The result has been significant and lasting, in the form of a 10- to 20-basis-point decline in implied yields on government bonds out to one year," deputy governor John Murray boasted yesterday in a speech in Philadelphia.

Whether the bank will be singing the same tune if conditions change and it has to increase rates before its one-year commitment is finished, is another question.

-Heather Scoffield, Globe and Mail

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