BoC pledges high bar to use pandemic playbook again
The Bank of Canada said the bar should remain “very high” for using emergency monetary policy tools, such as massive purchases of government bonds, after a postmortem of its response to the COVID-19 pandemic.
On Friday, the central bank published its most comprehensive review to date of the extraordinary measures it took to calm financial markets and prop up the Canadian economy during the early years of the pandemic.
These included quantitative easing (QE) – where the bank bought hundreds of billions of dollars worth of government bonds to suppress interest rates – and forward guidance (FG), where it promised to hold interest rates near zero for an extended period of time. Both measures drew criticism amid the subsequent surge in inflation and accusations that the bank duped Canadian homeowners with promises of low mortgage rates.
The bank defended these tools as “useful and necessary” in the context of an unprecedented health and economic crisis. However, it said that any future use of these tools should come with guardrails to avoid “moral hazard” in financial markets, clearer communication about goals and a well-defined exit plan.
“The Bank recognizes that these exceptional monetary policy tools should remain exceptional and be used only during periods of extreme economic stress,” the bank’s governing council said in response to the internal staff report.
The central bank committed to the internal review in 2023, at a time of heightened scrutiny from politicians as well as criticism from some economists. Its use of QE, in particular, was attacked by Conservative Party Leader Pierre Poilievre as the rate of inflation took off in 2021, reaching a four-decade high of 8.1 per cent in June, 2022.
Governor Tiff Macklem was also pilloried for promising Canadians in 2020 that the bank would keep mortgage interest rates low for a long time, only to start raising them rapidly in 2022.
The review, which was accompanied by an external assessment by two academics and a former governor of Spain’s central bank, largely avoids discussing the bank’s response to inflation – either its decision to hold off raising interest rates until the spring of 2022, or the ultra-aggressive rate-hike campaign that followed.
Instead it focuses on the use of emergency tools in the depths of the pandemic, and why the bank’s forecasting models failed to foresee the run-up in inflation.
The bank first resorted to large-scale asset purchases in March, 2020, to prevent financial markets from seizing up.
When the pandemic hit, investors dashed to sell their assets to raise cash, while buyers fled the market. The Bank of Canada stepped in as a buyer-of-last resort, with 10 different asset-purchase programs worth tens of billions of dollars. The goal was to keep markets functioning so that credit would continue flowing to households and businesses.
As markets stabilized through the spring and early summer of 2020, the bank continued to purchase around $5-billion worth of Government of Canada bonds every week. At that point, the goal shifted from market stabilization to lowering interest rates. The huge bond purchases morphed into QE – a monetary policy tool aimed at boosting the Canadian economy when the bank’s main tool, its policy interest rate, was already near zero.
All told, the bank purchased around $350-billion worth of Government of Canada bonds, between March, 2020, and the end of QE in late 2021.
The staff review determined that the bank did not do a good enough job delineating between its different financial stability and monetary policy goals, creating confusion about the nature of its asset purchases. The external assessment agreed with the finding.
“A clearer distinction would not only improve the communication around these programs, but also incentivize a careful consideration of the amount, duration and structure of any asset purchase program at each stage,” wrote the three outside experts, former Bank of Spain governor Pablo Hernández de Cos, Massachusetts Institute of Technology professor Kristin Forbes and University of Calgary professor Trevor Tombe.
The bank’s internal review said QE played an important part in supporting the economy through the pandemic downturn. It may have lowered 10-year bond yields by between 0.7 and 0.9 percentage points and boosted GDP by a percentage point or two, the review said, citing several studies. QE likely added to inflation on the margin, but the review said that it was not a major cause of high inflation that began in 2021, as some critics have suggested.
“After the 2008-09 global financial crisis, inflation was subdued in countries that conducted large QE programs. In Canada, although money growth and inflation increased following the pandemic, they did not move together before the pandemic. Additionally, inflation was high across all countries, even those that had minimal changes to their central bank balance sheet,” the bank said.
Still, QE has been controversial and has come with negative side-effects, including significant financial losses to the central bank. By greatly expanding its balance sheet, the bank became exposed to interest-rate risk, and it incurred major losses after raising interest rates rapidly to fight inflation.
In an appearance on Thursday, Bank of Canada deputy governor Toni Gravelle estimated that total losses from the QE program will add up to around $9-billion, and the bank likely won’t be made whole again until 2029.
The bank’s review also suggested that forward guidance could have been done better. Starting in the summer of 2020, Mr. Macklem promised to keep interest rates low for an extended period. This was an attempt to push down longer-term bond yields by influencing market expectations about monetary policy, thereby lowering borrowing cost across the economy. The intervention seems to have produced a “modest” boost to GDP growth, the review said. But it ended up confusing both investors and homeowners, undermining the bank’s credibility.
“Canadians were told they could be confident that rates would be low for a long time. In the future, the bank should be consistent in stressing the conditionality in all its communications,” the review said.
The external reviewers, Mr. Hernández de Cos, Prof. Forbes and Prof. Tombe, said the bank’s review was “detailed, balanced and credible.”
However, they pointed to a number of questions about the bank’s response to the pandemic and the subsequent surge in inflation that remain unanswered. For instance, could the bank have lowered its policy rate below 0.25 per cent before considering extraordinary actions such as QE? Other central banks around the world have experimented with ultralow, even negative interest rates.
They also suggested exploring the interaction between the bank’s extraordinary tools and the timing and size of subsequent interest-rate hikes. “Did the use of QE and/or forward guidance hinder the ability of the Bank to shift from providing stimulus to tightening monetary policy as inflation picked up? If so, are there ways to better design QE and FG so that it is easier to adjust policy when the economic environment changes?” they asked.
This article was first reported by The Globe and Mail
