MNI POLICY: BOC Paper Says Negative Rates Risky, Reviews Tools

Bank of Canada staff believe negative interest rates could backfire, and that a "helicopter money" approach to policy poses major risks and lacks historical precedent, according to an informal discussion paper published Wednesday.

The staff discussion paper reviewed economic literature covering extraordinary monetary policy options, focusing on small open economies like Canada.

"The analysis is informative for tool design and implementation strategies, such as sequencing and pacing tool deployment" as well as considering financial stability concerns, according to the report. The authors include Grahame Johnson, managing director of the financial markets department, and Sharon Kozicki, a Governor's adviser since 2013.

The BOC has cut interest rates to an "effective lower bound" of 0.25%, is purchasing at least CAD4 billion a week of bonds to tackle the Covid-19 pandemic, and has offered forward guidance around both programs, moves that have been studied by the Federal Reserve. The paper's findings about the benefits of QE and guidance, as well as misgivings about negative rates and direct financing of government deficits, are in line with views expressed by Governor Tiff Macklem.

Yield curve control "appears to be a useful policy to lower yields and enhance the effectiveness of other tools such as forward guidance," the paper said. " Sources have told MNI that the dominance of five-year borrowing for mortgages and business loans may make it easier for Canada to formally or informally control yields around that range.

EXIT STRATEGIES

"While some countries have provided additional monetary stimulus by reducing policy rates into negative territory, policy rate decreases may become less and less stimulative—even when rates are still slightly above zero—and may even become contractionary," the paper said. Helicopter money has never been used by any major economy, so all discussion of this option is theoretical, and the risks including governance are significant, the authors wrote.

The paper also discussed considerations for exit strategies, noting no major economy has yet unwound QE. The BOC slowed the pace of QE from CAD5 billion earlier this year and focused purchases on longer-term assets, saying that would provide just as much stimulus. Governor Macklem also has said QE will continue until the recovery is well underway, and a full exit is too far away to advance any detailed plans.

"Carrying an elevated balance sheet for a prolonged period of time has several potential unintended consequences, including on market functioning, on meeting Basel III requirements, and on the behavior of banks, market participants and governments," according to the paper.

Negative interest rates eventually hurt bank profits and cause others to hold cash rather than hold savings, the paper said. Canadian banks also did not pass on the full extent of policy interest-rate cuts below 1% in 2008 to prime lending rates.

CURRENCY EFFECTS

While QE in a small open economy may be less powerful given global bond flows, "it can be effective via a depreciation of the exchange rate," the paper said.

"Foreign asset purchases can also be effective, though most often the intervention is to fend off appreciation pressures that are pushing the currency away from its fundamentals (rather than to provide broader monetary easing)," the paper said.

Macklem has noted Canada's dollar strengthened this year amid a global U.S. dollar fade, rather than because of domestic strength.