MNI INSIGHT: BOC To Adjust, Not Expand, QE To Support Recovery

The Bank of Canada is likely to focus on adjusting the type and duration of its asset purchases to support economic recovery rather than to expand the size of its quantitative easing program after its balance sheet surged to a record CAD550 billion in July.

With QE's initial objective of stabilizing financial markets after March's extreme volatility now achieved, the BOC is free to concentrate on restoring inflation to its 2% target, via purchases of least CAD5 billion a week of federal bonds until recovery is well underway. While details of this program may shift, with the government saying Friday that it will pay for deficit spending by locking in low long-term interest rates, the Bank may distinguish between temporary stimulus and more permanent programs.

Shifting some purchases to longer durations may boost QE's effectiveness, although MNI understands the BOC is unlikely to concentrate on the shorter end of the yield curve, targeted in places like Australia, as in Canada more mortgage and corporate lending is done around the 5-year area.

The Canadian dollar may strengthen against peers in Australia and New Zealand because of the potential for less balance sheet expansion, according to ING FX strategist Francesco Pesole, while Craig Alexander, chief economist at Deloitte Canada, said gradual recovery could allow the BOC to scale back QE next year.

MAINTAIN, NOT ADD, STIMULUS

Even in a major second Covid wave, "the first line of defense here is fiscal policy, not monetary policy," said Alexander, who has testified half a dozen times to parliament's economic committee.

"If we have small setbacks or we have some volatility in the economy, I think it's more about the Bank of Canada maintaining stimulus in the economy, rather than injecting more," he said.

The Bank's assets have leveled off since surging from CAD125 billion in March. The rush of T-bills and corporate repos bought in the spring when markets froze and the government needed cash to fight Covid-19 has started to reverse, while provincial government and corporate bond programs are not being fully used and are set to wind down in May.

The government's desire for low rates may eventually put the BOC in an awkward spot, said Pedro Antunes, Conference Board of Canada chief economist and a former BOC researcher.

"The Bank can keep doing this and feel comfortable doing this in an environment when inflation is really weak," Antunes said. "We are going to keep bond yields low for the next little while, because the economy globally and in Canada is really in a tough spot right now, but three or four years down the road, I'm not convinced."

The Bank must also think about whether it can hold down domestic yields if big deficits prompt the return of inflation pressure and drive up global borrowing costs, he said.

NO CROWDING OUT

Policy makers must ensure asset purchases do not favor government spending ahead of private sector recovery, says Robert Asselin, Business Council of Canada senior vice president of policy and a top aide to former Finance Minister Bill Morneau.

"If we want the Bank to keep buying these bonds and keeping inflation below target and interest rates very low, are we saying that basically we aren't counting on any growth, any investments for businesses? That I think is a worrying message," Asselin said.

BOC officials say QE produces benefits across the curve. Governor Tiff Macklem said in response to an MNI question on Sept. 10 that calibrating QE means "we will be assessing what to buy, as well as how much to buy. Could be more, could be less." In an earlier speech he ruled out the idea that central banks could more directly underwrite government deficits.

With debt markets functioning, the need for bigger asset purchases is questionable, said Michael Devereux, a former BOC research fellow who teaches at the University of British Columbia. But any quick reduction in the balance sheet is out of the question given fears of a "taper tantrum"-like episode and the upcoming renewal of the inflation target agreement with the government.

"The Bank will want to be in a situation where they can argue that their LSAPs were well targeted and effective," he said.