MNI INTERVIEW: BOC Will Struggle to Unwind QE: C.D. Howe

The Bank of Canada will face a difficult task scaling back QE when the economy recovers, because of government borrowing, the need to keep inflation on track and the potential for a taper tantrum, former BOC analyst and associate research director at C.D. Howe Institute Jeremy Kronick told MNI.

While the first part of reducing QE is simply allowing corporate repos to roll off the balance sheet as they come due, sales of other assets could be more difficult, Kronick said in an interview. In addition to purchases of at least CAD5 billion a week of federal bonds, the BOC has programs to buy up to CAD50 billion of provincial debt and CAD10 billion of corporates, which end in May.

"The real fight will be in the medium to long run. They did what they needed to do in the short run," he said. The Bank, whose assets have grown to a record of almost CAD550 billion this year from CAD125 billion before markets froze during the pandemic, now faces challenges akin to those of the U.S. Federal Reserve, which never significantly shrank its balance sheet after the global financial crisis, he said in an interview.

MANDATE RENEWAL

With the government planning to rely on low interest rates to finance record deficits, the growing entwinement between fiscal and monetary policy could also complicate talks over the renewal of the BOC's 2% inflation target next year, said Kronick, whose institute runs shadow councils on monetary policy and on dating recessions.

"They both have to be aware of" perceptions of political intervention, he said. "People will find ways of saying you chose this because it works best for the government."

The BOC is likely to state in the renewal that it will take more time than the usual six to eight quarters to bring inflation back to target, Kronick said. Another possibility, as he spelled out in a paper with former BOC special adviser Steve Ambler earlier this week, is that the central bank could follow the Federal Reserve's move to an average inflation target for a few years.

The government could make the BOC's life easier by recommitting to a fiscal target, showing markets that fiscal and monetary officials are working to avoid a dangerous collision of rising policy interest rates and deficits.

"The problem is if the government has racked up a ton of debt, that higher interest rate is going to make that debt more expensive to service," Kronick said. A fiscal anchor "forces the finance minister to take that into account when setting the budget, and so that's why those anchors in combination are so important."

For now the challenge is mostly one-sided, with consumer prices flat and the nation facing a second Covid-19 wave. But over the next few years inflation risks may become more balanced, Kronick said, because unlike during the recession a decade ago when the money supply shrank, today it is gaining rapidly.

INFLATION DANGER

Inflation could jump without an equivalent pickup in growth, sending bond yields surging, he said. Selling back assets would add to upward yield pressure, further complicating the BOC's calculations as it seeks to manage QE and decide when to lift today's 0.25% policy rate.

The Bank would put the inflation target first, Kronick said.

"You can live with an inflated balance sheet," he said, adding that even in that case "you can still have trouble hitting the inflation target.

"The question is going to be if inflation appears in an economy that's not in the best of shape."