Steve Ambler is a professor at the University of Quebec at Montreal and David Dodge Chair at the C.D. Howe Institute. Jeremy Kronick is a senior policy analyst at the C.D. Howe Institute.
In the Great Recession of 2007-2009, the Bank of Canada was able to minimize the damage to the Canadian economy relatively easily. However, the low interest rate environment continuing to dog all central banks is likely to make the bank's current monetary policy tool kit insufficient to deal with any repeat of 2007-2009.
The government of Canada and the Bank of Canada announced the renewal of the inflation-control target on Oct. 24. The announcement contained no surprises, leaving the main features of the previous control target unchanged. For the next five years, the target will remain a year-over-year growth rate of 2 per cent in the consumer price index, expressed as the midpoint of a 1- to 3-per-cent range.
However, the Bank of Canada had been studying the possibility of raising the inflation target above 2 per cent. A number of economists had recently suggested that a higher inflation target could be beneficial because another economic slowdown would push central banks' policy rates to their effective lower bound. The bank, however, decided against any increase, for entirely valid reasons.
An increase in the target would have surprised markets, possibly leading to a loss of credibility of the new target and expectations of further increases. With expected inflation higher than the new target, the bank would have had to tighten monetary policy – that is, increase interest rates – just to re-establish its credibility. Higher inflation would also create a fall in the real rates of return on nominal assets, causing a surprise redistribution of wealth from savers to borrowers. In other words, raising the inflation target would have been a serious policy error.
Despite these credible arguments for keeping the inflation target at 2 per cent, the low-interest-rate problem that precipitated the analysis of higher targets in the first place is very real, and will likely continue to be so. Why is that? Most economies, including Canada's, have been suffering from slow productivity growth and aging demographics. These economic factors drive down the neutral rate of interest – the overnight rate that would prevail with inflation at target and the economy at cruising speed. A best guess has this neutral rate somewhere between 3 and 4 per cent – at least a full percentage point lower than before the 2008 financial crisis. It means that there is less room for the bank to cut the overnight rate today before its effective lower bound is reached.
The bank has stated that its unconventional monetary policy tool kit – including negative policy rates, forward guidance, large-scale asset purchases, and funding for credit – can reduce the probability and severity of lower-bound episodes.
However, this arsenal of tools is unlikely to be sufficient for a recession of the severity of the one that hit most industrialized economies in 2007-2009.
In a just-published C.D. Howe Institute paper, one of us (Steve Ambler) suggests that the missing tool is a sustained increase in broad money supply designed to boost inflation expectations. When the nominal interest rate is at its effective lower bound, yet the economy needs lower real (after-inflation) interest rates to provide continued stimulus, central banks must rely on driving up inflation expectations.
So how does this happen in today's economy? The bank can purchase assets from chartered banks, and if these banks then expand their lending this would drive up broad measures of the money supply. However, with short-term interest rates very low and banks, therefore, having little incentive to expand their loans, the bank can purchase assets directly from the private sector. The liquidity of private-sector portfolios would then increase, and in seeking to rebalance their portfolios, firms and individuals would run down their liquid assets by purchasing less liquid assets or by directly purchasing goods and services. For this scenario to happen on aggregate, nominal spending and/or the price level must increase – a nice result for an economy stuck with low growth, low inflation and low interest rates.
There is abundant evidence that for increases in the money supply to be effective in stimulating demand, they must be very persistent if not permanent. In order to make its commitment to a sustained increase in the broad money supply credible, the bank would have to establish a firm endpoint for the level of a nominal aggregate. This could be the level of nominal income or the future level or path of prices. In either case, the bank must remain committed.
This additional tool would improve the Bank of Canada's preparedness for a repeat of a downturn like the Great Recession, which may not spare Canada from the worst of its effects next time.