(Bloomberg) — The Bank of Canada says the bar for using exceptional monetary policy tools like quantitative easing and extraordinary forward guidance “should remain very high,” after reviewing its response to the Covid-19 pandemic to inform how it reacts to future crises.
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In a suite of documents released Friday, the central bank offered a wide-ranging review of its handling of the economic shock brought on by the novel coronavirus in early 2020. The report comes as US President-elect Donald Trump threatens tariffs that would likely tip Canada into a recession if enacted.
“The bank recognizes that these exceptional monetary policy tools should remain exceptional and be used only during periods of extreme economic stress,” it said in the documents.
The bank examined its use of quantitative easing, or large-scale government bond buying, during the pandemic. It acknowledged the so-called moral hazard — the potential for market participants to take greater risks assuming the cental bank will step in to intervene. To guard against that outcome, the bank said it would be “clear about the limited circumstances under which it will conduct” these purchases.
The central bank said that moving forward it also recognizes the need to distinguish between large asset purchases that are intended to support market functioning, and those that are intended to put downward pressure on yields. It said it deployed the former in the early days of the pandemic, and the latter beginning in July 2020.
“In the event that the bank needs to deploy such operations in the future, the bank will make more concrete the distinction between asset purchases to restore market functioning and asset purchases for monetary stimulus,” the bank said.
Citing multiple studies, the bank said quantitative easing added between 0.2 and 3% to the country’s gross domestic product at its peak. The emergency bond purchases added between 0.1 and 1.8 percentage points to inflation, though the bank says the estimates “may not give an accurate picture.”
In 2020, one of Governor Tiff Macklem’s first and most controversial decisions was to communicate to Canadians that interest rates would remain low for longer than markets expected, encouraging households to make large purchases if they were considering doing so.
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In an executive summary of the bank’s review, policymakers said that one risk of extraordinary forward guidance is “is that efforts to communicate it as simply as possible can lead markets or the public to interpret it as a broader guarantee than intended.”
The bank’s governing council agreed that the use of extraordinary forward guidance should always be “conditional” moving forward and be tied specifically to the inflation outlook. In 2020, the central bank’s pledge to keep interest rates lower for longer was dependent on the output gap — an abstract theoretical measure of economic slack.
“If a central bank does not follow what it is perceived to have said, it can be accused of breaking its promise,” the bank said.
The central bank is now faced with another period of major economic uncertainty. Trump has threatened 25% tariffs on imports of Canadian goods, and Prime Minister Justin Trudeau government has signaled it intends to retaliate with escalating levies of its own.
On Thursday, Deputy Governor Toni Gravelle said the potential for rising inflation and economic damage complicates the bank’s response.
The review also comes amid a rapidly changing political situation. Trudeau plans to resign, and his Liberal Party is seeking a new leader. Conservative Party Leader Pierre Poilievre is leading by a hefty margin in the polls, and has slammed the central bank for its first-ever foray into quantitative easing, saying it contributed to inflation. During his campaign for the party leadership in 2022, he even threatened to fire Macklem.
Economists Pablo Hernández de Cos, Kristin Forbes and Trevor Tombe reviewed the central bank’s report, which they themselves deemed “broadly positive.” Still, they raised some concerns.
They questioned why the bank’s review didn’t include a broader discussion of why 0.25% was chosen as the effective lower bound for interest rates, and why officials opted for quantitative easing and forward guidance instead of deeper rate cuts.
“Did the bank debate if the lower bound had changed and whether lowering the policy rate further in response to the pandemic could have reduced its use of unconventional tools?” they asked. They also questioned whether interest rates would have had to move as aggressively higher in 2022 if the central bank had provided less stimulus during the crisis.
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