Download Is zero-inflation and central bank independence still relevant?

Monetary policy in a period of
financial chaos
Is zero-inflation and central bank
independence still relevant?
Clinging to inflation targeting
• While the rest of the world is plunging into financial
chaos and depression, the Bank of Canada still claims
that:
• “Low, stable, and predictable inflation is the best
contribution that monetary policy can make to the
economic and the financial welfare of Canadians”
(Monetary Policy Report, April 2009, p. 25; same
sentence in Carney’s speech of 1st of April 2009).
• “Any unconventional action initiated by the Bank must
have as its primary objective the achievement and
maintenance of the Bank’s 2 per cent inflation target”
(Deputy Governor Murray, May 2009)
The Bank can’t even predict future growth
Year
2006
2007
2008
2009
Semester
I
II
I
II
I
II
I
Realized rates
2.85
1.6
3.9
1.4
0.5
-0.7
-1.2
12 months ahead
*
2.9
2.9
2.7
2.8
2.5
2.7
2.2
6 months ahead
2.9
3.2
2.5
2.6
2.1
1.8
0.4
0.7
Realized real GDP quarter-over quarter percentage change,
averaged per semester,
versus base-case projections of the Bank of Canada
II
The world was in turmoil in
August and September 2007…
2000
Millions $
1600
1200
800
400
0
7/30/07 8/06/07 8/13/07 8/20/07 8/27/07 9/03/07 9/10/07
Actual LVTS Settlement Balances
Source: Bank of Canada, http://www.bank-banque-canada.ca/en/rates/interest-look.html
And also in the Fall of 2008 …
3000
2500
Millions $
2000
1500
1000
500
0
-500
2008M09
2008M10
Actual LVTS Settlement Balances
Source: Bank of Canada, http://www.bank-banque-canada.ca/en/rates/interest-look.html
While the Bank remained obsessed
with inflation targeting
• Two weeks after the near-meltdown of interbank
lending on August 13, 2007, Deputy Governor
Duguay’s speech was about whether Canada
should move to price level targeting (August 27)
• (also Deputy Governor Jenkins Oct 2007).
• One year later, Deputy Governor Murray was
discussing how best to measure inflation
(September 18, 2008).
• The latest issue of the Bank of Canada Review
(21 May 2009) is entirely devoted to the issue of
whether the inflation target should be lowered
and whether the Bank should abandon inflation
targeting in favour of price level targeting.
Lowering the inflation target: Milton
Friedman born again
• The most abstract models conclude that
the optimal inflation rate is negative
(deflation) and equal to the growth rate of
productivity.
• We are back to Friedman’s optimal theory
of money, according to which the nominal
interest rate ought to be zero, with the real
rate equal to the growth rate of
productivity.
0% inflation target now
• One major objection against lowering the
inflation target is that there would be large
unemployment costs during the transition
period to the lower inflation rate.
• Clearly now would be the best time for the
Bank of Canada to implement 0% inflation
targeting or price level targeting, as the
subprime crisis has already brought the
inflation rate close to zero.
Price-level targeting
• Most studies seem to show that price-level
targeting is preferable to inflation targeting.
• It reduces uncertainty about the future price
level.
• This obsession with the stability of the price level
is rather surprising given that Canada is on a
pure flexible exchange rate regime, with the
Canadian dollar having moved from US$0.80 to
$1.10 and then back to $0.80, giving rise to
great price uncertainty for exporters.
0% inflation and expansionary
policy
• “The significance of the zero lower bound has
increased significantly in the aftermath of the
2007 subprime-mortgage meltdown … Further
research focusing specifically on the
connections between the inflation target and the
zero lower bound … should be a priority in the
future” (Amano, Carter, Coletti, 2009).
• What? It was not really considered up to now?
Central bank independence is an illusion
• During the fight against the financial meltdown:
• The balance sheet of the Bank of Canada
jumped up from $53 billion in August 2008 to
$80 billion in March 2009;
• The total amount of Government of Canada
securities outstanding jumped up from $402
billion in August 2008 to $497 billion in March
2009.
• This was before the government started
accumulating deficits.
Central bank independence is an
illusion
• “Just as the boundary between monetary
stability and financial stability becomes
increasingly blurred in the midst of a
financial crisis, so too does the boundary
between monetary and fiscal policy
actions. It isn’t uncommon for both central
bank and governments to initiate crediteasing measures, and it is important that
the two work together” (Deputy Governor
Murray, 19 May 2009).
Where did all these government
securities go?
Bank assets
August 2008
March 2009
Mortgages
487
434
Corporate
securities
T-bills
168
116
28
53
Canadian govt
bonds
Total
126
211
1733
1787
Where did the mortgages go?
• They were purchased by the Canadian
Mortgage and Housing Corporation
(CMHC) to the tune of $51 billion as of
March 2009, through the Insured
Mortgage Purchase Program.
• $125 billion has been set aside for this (25
in September 2008, 50 in November 2008
and 50 in the January 2009 Budget)
• The program now seems to be stalling.
How did CMHC acquire the mortgages? It got loans from the federal government
Banks
Assets
CMHC
Liabilities
Mortgages
-$50 B
Govt Securities
+$50 B
Assets
Liabilities
Mortgages
+$50 B
Loans from
federal govt
+$50$ B
Federal government
Assets
Liabilities
Claims on CMHC +$50 B
Securities +$50 B
Bank of Canada balance sheet (in billions of dollars)
Assets
53.5
80.4
Liabilities
Aug
2008
March
2009
Aug
2008
March
2009
Bills
22.4
13.8
Notes
50.0
51.2
Bonds
30.8
31.5
Govt
2.3
deposits
28.1
PRA
0.2
34.8
Bank
0
reserves
0
There is (nearly) no increase in the monetary base
PRA: Purchase and Resale Agreement
Three strategies to improve the liquidity of
the balance sheet of banks.
• First, banks sold some of their mortgages to the
CMHC, obtaining bonds.
• Second, the Bank of Canada granted 28-day
purchase and resale agreements (PRA) backed
by ABCP and less liquid securities (long-term
federal, provincial), sterilizing these purchases
by selling the T-bills that it held to banks.
• Third, the Bank granted 28-day purchase and
resale agreements (PRA) backed by the same
less liquid assets, sterilizing these purchases by
first acquiring T-bills from the federal
government, and then selling these T-bills to
banks.
Table 5: Composition of the term purchase and resale
agreements conducted by the Bank of Canada (in
billions of dollars)
2008
November
December
Government of
securities
Provincial securities
16.0
20.7
9.8
8.0
Municipal securities
0
0.1
Corporate securities
5.7
5.6
ABCP
2.9
3.2
Total
34.5
37.7
Evolution of Assets of Bank of Canada
40000
Millions $
30000
20000
10000
0
2008M07
2008M10
2009M01
2009M04
2009M07
Repos and other assets
Bonds
Advances
Treasury bills
Source: Statistics Canada, CANSIM Series V36612, V36613, V36634, V36635, and V44201362.
Evolution of liabilities of Bank of Canada
60000
50000
Millions $
40000
30000
20000
10000
0
2008M07
2008M10
2009M01
2009M04
2009M07
Government Deposits
All Other Liabilities
Notes in Circulation
Bank Deposits (Reserves)
Source: Statistics Canada, CANSIM Series V36625, V36628, V36632, and V36636.
Impact of term PRA operations on LVTS balances when the size of
the balance sheet of the Bank of Canada is rising
Banks
Assets
Long securities -$30 B
LVTS balances +$30 B
Bank of
Liabilities
Assets
Liabilities
Term RPAs +$30 B
LVTS balances -$30 B
T-bills +$30 B
T-bills +$30 B
LVTS balances -$30 B
T-bills -$30 B
LVTS balances +$30 B
Long-term securities -$30
B
T-bills +$30 B
Term RPAs +$30 B
Government
deposits +$30 B
Government
deposits +$30 B
The Bank of Canada claims that conventional
monetary policy is now helpless
• The inflation rate is approaching negative
territory and the overnight interest rate is nearly
at zero, so that the real overnight rate can’t be
negative anymore.
• The spreads between the overnight rate and
market rates are much higher than they used to,
so that the reduction in the overnight rate has
not been as effective as if spreads had remained
constant.
• Since 2007 QIII, loan officers have been
tightening lending conditions, and still are.
Rising spreads
Evolution of Spread between Prime Corporate Paper Rates
and the Overnight Rate, Canada 2005-2009.
.7
.6
Percentage Points
.5
.4
.3
.2
.1
.0
-.1
-.2
2005
2006
2007
2008
Spread Prime Corporate Paper (1 Month) and the Overnight Rate
Spread Prime Corporate Paper (3 Months) and the Overnight Rate
Source: Statistics Canada, CANSIM II, Series V122491, V122509, and V 39050.
Tightening credit conditions
Source: Bank of Canada website, Senior Loan Officer Survey, 9 October 2009
The new framework at zero-interest
rate policy (ZIRP)
1.
2.
3.
4.
Conditional promise to keep the target overnight rate
where it is for more than a year
Set the deposit rate on bank balances at the target
overnight rate
Quantitative easing (unsterilized operations)
Credit easing (sterilized or unsterilized): the Bank
purchases certain private sector assets in certain
credit markets). This is already done indirectly through
the PRA program where collateral can be ABCP, and
through the purchases of the CMHC. This could be
done to reduce interest rates on private assets relative
to safe government assets.
Conditional statements
• By promising to keep the target interest rate at
0.25% for more than a year, the Bank hopes to
lower medium-run rates.
• The Governor (6 May 2009) claims that as a
result “interest rates across the maturity horizon
of the commitment fell”.
• The promise is conditional because the Bank
fears that if interest rates were fixed without any
consideration of possible inflation pressures, this
might lead instead to rising medium-term rates.
Yields on Canadian government bills after
promise to keep interest rates down
Source: Bank of Canada, 19 May 2009
The standard framework
vs the new ZIRP framework
Overnight rate
25
Bank rate = TR+25pts = 0.75
Target rate TR = 0.50
Rate on positive
balances = TR-25pts = 0.25
- (overdraft) 0 + (surplus)
Settlement
balances
The standard framework vs
the new ZIRP framework
But if things go wrong, there is no incentive to lend on the overnight market;
Banks would rather deposit their excess funds at the Bank, at the same rate.
Overnight rate
3000
Bank rate = TR+25pts = 0.50
Target rate =
Rate on positive balances
= 0.25
- (overdraft) 0 + (surplus)
Settlement
balances
An alternative? Shrink the band
Overnight rate
25
Bank rate =
TR+12.5pts = 0. 375
Target rate TR = 0. 25
Rate on positive
balances = TR-12.5pts
= 0.125
- (overdraft) 0 + (surplus)
Settlement
balances
Quantitative easing
• In a sense, between April 2009 and May 2010,
we were in a kind of quantitative easing
situation.
• Since 21 April 2009, settlement balances are set
each day at $3 B by the central bank (banks
have $3B reserves, instead of zero as before).
• The only difference is that, instead of the excess
settlement balances being provided by moving
around government deposits, quantitative easing
would provide the excess balances through
open market operations (or by purchasing
private assets).
Conventional vs unconventional policies
• There is a lot of irony with the current situation. What is
now called conventional monetary policy is a slightly
modified version of the kind of policy implementation
advocated since the late 1950s by heterodox and postKeynesian economists. It has become conventional
policy once more since the early 1990s, after the demise
of monetarism in the mid 1980s.
• By contrast, unconventional monetary policy, in
particular quantitative easing, is the kind of monetary
policy implementation that can be found in nearly every
neoclassical textbook and that central bank economists
faked to pursue.
• Officials at the Bank of Canada are quite aware of this
paradox, and are obviously uncomfortable with it, as the
following statement shows.
Bank of Canada balance sheet (in billions of dollars)
Assets
80.4
75.3
Liabilities
March
2009
May
2009
Bills
13.8
13.1
Notes
Bonds
31.5
PRA
34.8
March
2009
May
2009
51.2
52.0
32.5
Govt
28.1
deposits
19.1
29.4
Bank
0
reserves
3.0
Misleading claims on behalf of
quantitative easing
• “The expansion of the amount of settlement
balances available to [banks] would encourage
them to acquire assets or increase the supply of
credit to households and businesses. This would
increase the supply of deposits” (Bank of
Canada, Monetary Policy Report, Annex, 23
April 2009).
• “[Quantitative easing injects] additional central
bank reserves into the financial system, which
deposit-taking institutions can use to generate
additional loans” (Deputy Governor John
Murray, May 2009)
Quantitative easing = mistaken
textbook story
• “Although quantitative easing is now referred to as an
unconventional monetary policy tool, the purchase of
government securities is, in fact, the conventional
textbook approach to monetary policy…. In practice,
most central banks have chosen to conduct monetary
policy by targeting the price of liquidity because the
relationship between the amount of liquidity provided by
the central bank and monetary aggregates on the one
hand, and between monetary aggregates and aggregate
demand and inflation on the other, are not very stable.”
(Bank of Canada, Monetary Policy Report, Annex, 23
April 2009).
Quantitative easing = monetarism
• “All quantitative easing is, by definition,
‘unsterilized’. Although this is correctly
viewed as unconventional, it closely
resembles the way monetary policy is
described in most undergraduate
textbooks, and is broadly similar to how it
was conducted in the heyday of
monetarism” (Deputy Governor John
Murray, May 2009).
Quantitative easing is useless
• It assumes that credit is supply-constrained.
• It assumes that banks will grant more loans
because they have more settlement balances.
• The only effect might be to lower interest rates
on some assets. Will this have an impact on
lending rates or on the exchange rate?
• Experience with the Bank of Japan: “Given that
the interest rate is zero, no policy measures are
available to lift the inflation rate to positive
territory… The Bank did not have the tools to
achieve it” (BoJ arguments as assessed by Ito,
1994).
Rough evolution Oct. 2008-March 2009
T-Bills
Govt
B of C
Banks
-100
-10
+110
Mortgages
Deposits
at B of C
+25
FGBE
-45
-30
+75
-50
+20
+30
+30
-30
-25
Deposits
at banks
ABCP
Bank loan
+20
PRA
+35
Claims
+75
Total
0
House’lds
NBFI
-20
-35
-75
0
0
0
0
0
The inflation band and the present
recession
• This is a real challenge for the Bank of
Canada.
• We will see whether the Bank can truly
control inflation rates.
• The officials at the Bank of Japan did not
believe that inflation targeting was useful
when the central bank was trying to raise
the rate of price inflation (instead of
reducing it).
Pushing on a string
• During times of deep recession, the
monetary emperor has no clothes.
• Central banks can only act as a lender of
last resort, stopping the meltdown.
• Central banks can only be a useful
appendage to expansionary fiscal policy,
with the latter doing the important work of
reversing the downward trajectory of the
private sector.