Divergent paths for Federal Reserve and Bank of Canada bring up important questions
The Bank of Canada and the Federal Reserve have recently announced two contrasting approaches to monetary policy, with the latter declaring a major shift to its framework by targeting average inflation of 2%. And according to a recent note from the CD Howe Institute, each institution will confront different questions along its policy path.
“In the current context, the Fed’s AIT [average inflation targeting] policy, if credible, will increase expected inflation,” wrote Jeremy Kronick, the institute’s associate director, Research, and Steve Ambler, David Dodge Chair in Monetary Policy at the institute.
According to the two, the Fed’s commitment to letting inflation run above 2% after periods when the U.S. goes below target spells an increase in expected inflation. In turn, real interest rates – nominal interest rates adjusted for inflation – will rise.
But for any AIT policy to be credible, they said it should specify the exact timeframe over which average inflation would be defined. Critically, the policy should also be explicitly symmetric, acknowledging both persistent undershoots and overshoots to allow medium-term inflation to sit at the 2% target; otherwise, market expectations for inflation become unanchored – and biased upwards, in the Fed’s case – creating a problematic scenario given the unprecedented level of debt flooding markets.
And while the BoC has generally stayed the course on its own monetary policy, Ambler and Kronick still had some questions. An important one, they said, is whether the bank’s commitment to QE can continue to provide economic stimulus if markets have been calmed and yields across the curve are already quite low.
“On September 9, the yield on 10-year government bonds was 0.592 percent, just 34 basis points above the target overnight rate,” they wrote. “Shorter-term yields on government bonds (one year or less) were all below the target overnight rate.”
Given those numbers, they said any effort by the BoC to push down yields via QE will likely do so only marginally. They also suggested that a healthy spread between short- and long-term yields could be desirable, as it would signal a pick-up in inflation expectations.
“Some ground that the Bank of Canada could safely explore is its thinking on the overnight rate,” the two said. Citing the bank’s own research, they said the effective lower bound on the Target Overnight Rate is actually as low as -50 basis points.
While the case for maintaining the current lower bound of 25 basis points is supported by reasons such as preserved lending spreads for financial institutions, Ambler and Kronick suggested that the BoC consider lowering “the interest to financial institutions on what amounts to a significantly higher level of settlement balances held at the central bank.
“For the first time since the Bank became an inflation-targeting central bank, it is giving serious consideration to an alternative framework, of which AIT is one option,” they said. “Extraordinary times call for extraordinary measures. A move to AIT might not seem it, but in the context of central banking, it would be.”
