Bank of Canada at the Zero Lower Bound: The Export Price Norm to the rescue

The continued drop in the oil prices have caused the Bank of Canada to reconsider whether it should cut it key policy rate – the Overnight rate – and in a speech earlier this week BoC governor Stephen Poloz said that he would not rule out negative interest rates in Canada even though he did not expect it and he also voiced some worries about negative rates in general.

I overall think it is prudent for the BoC governor to remind the markets that the BoC is not “out of ammunition” (I hate that expression when it comes monetary policy). The reason for this is that if Poloz instead had said “we are approaching the Zero Lower Bound and below zero there is nothing more we can do to ease monetary policy” then surely we would have seen a strong market reaction – the lonnie would have strengthened, (market) inflation expectations would have dropped, Canadian stocks would have dropped and that all on its own would have been monetary tightening.

Instead he rightly reminded the markets that the BoC certainly can cut rates below zero, but there certainly is also other options. The most obvious is quantitative easing – the BoC could purchase assets – e.g Canadian Treasury bonds.

I therefore also very much welcome that the BoC a couple of days ago published a paper on how to conduct monetary policy at “low interest rates” (Poloz’s speech was based on this paper). I do not agree on everything in the paper, but I clearly think that it is right that the BoC already now makes it completely clear to the markets that it has lots of options to ease monetary policy if needed – also with interest rates close to the Zero Lower Bound (the Overnight Rate is presently at 0.5%).

Hence, this means that if oil prices continue to drop – this by way is a negative demand shock for the oil-exporting Canadian economy – the markets would not have any reason to doubt that the BoC will move to ease monetary conditions to ensure nominal stability.

Consequently if oil prices drop then rational investors should expect monetary easing and that in itself would cause the Canadian dollar to weaken, which on its own should do a lot to offset the negative demand shock from lower oil prices.

The Export Price Norm to the rescue

The question is, however, how the BoC could (and would) ease monetary conditions at the Zero Lower Bound. Obvious one possibility would be to cut rates below zero, but there are numerous reasons why the BoC would be reluctant to do this and there probably also at least a mental limit (among central bankers) for just how negative rates could become.

Another obvious option would be to do quantitative easing. However, central bankers aren’t to happy about this option either.

There is, however, an alternative to QE and negative interest rates, which I think the BoC should consider and that is the exchange rate channel.

My concrete proposal is that the BoC could combine two related ideas – Bennet McCallum’s MC rule (not to be confused with the McCallum money base rule) and my own Export Price Norm (inspired heavily by Jeff Frankel’s Peg-the-Export-Price).

In McCallum’s 2005 paper “A Monetary Policy Rule for Automatic Prevention of a Liquidity Trap? he discusses a new policy rule that could be highly relevant for the BoC today. What McCallum suggests is basically that central banks should continue to use interest rates as the key policy instrument, but also that the central bank should announce that if interest rates needs to be lowered below zero then it will automatically switch to a Singaporean style regime, where the central bank will communicate monetary easing and tightening by announcing appreciating/depreciating paths for the country’s exchange rate. This is the MC rule.

My suggestion would be to take McCallum’s MC rule one step further and would be for the BoC to announce that it would peg the Canadian dollar to a basket of currencies and the oil price and maintain that rule as long as core inflation is below the BoC’s 2% (operational) core inflation target (which is presently not the case).

A Canadian Export Price Norm: 65% US dollar, 20% Asian currencies and 15% oil prices 

Since the BoC started targeting inflation in the early 1990s the central bank has done a very good job of hitting the inflation target and furthermore, nominal spending growth has also be quite stable. As a result we have also – as a positive side-effect had a fairly high level of real stability in the economy.

This means that if monetary policy in general has been “good” then the outcome on different financial variables that reflect this policy could be seen as good monetary policy indicators. So if we for example look at the Canadian dollar then the development in the dollar should reflect “good” monetary policy.

So if we can construct a basket of currencies and the oil prices that would “track” the historical development in the Canadian dollar then that could serve as BoC’s operational exchange rate target to be “switched” on if conditions demanded it (a negative demand shock, disinflation, ZLB etc.).

I have constructed such basket. It is 65% US dollars, 20% Asian currencies (10% Korean won and 10% Japanese yen) and 15% oil prices (this by the way more or less reflects Canada’s trading patterns). By pegging to this basket we get an implied rate for the Canadian dollar against the US dollar that would keep the basket fixed (the Export Price Norm).

CAD Export Price Norm

As the graph shows the implied USD/CAD rate (the Export Price Norm) has tracked the actual USD/CAD rate quite closely in the past 20 years and as monetary policy overall in this period has been “good” I would argue that this basket would be a useful basket to implement for Canada.

But I should also stress that I am not arguing that BoC should give up it’s present monetary policy regime – just that the BoC should announced that it can use an Export Price Norm as a policy instrument to ensure nominal stability if needed (inflation drops below then inflation target and interest rates are stuck at the Zero Lower Bound).

That said, I don’t think the Export Price Norm should be implement right now – even though it could be a good idea to pre-announce it – as core inflation seems to be pretty well-anchored and the Canadian economy is doing fairly well. Furthermore, with the overnight rate at 0.5% we are still not at the Zero Lower Bound so the first step could be to cut the overnight rate to zero (maybe already now).

And finally, if it is notable that since USD/CAD more or less has tracked the Export Price Norm during the recent massive drop in oil prices there is really no indication that the markets in general are loosing trust in BoC’s ability and willingness to ease monetary conditions to offset the demand shock from lower oil prices. This is very encouraging and Governor Poloz luckily seems to understand the need to communicate to market participants that the BoC will continue to ensure nominal stability also if interest rates hit the Zero Lower Bound.

PS Read Bob Hetzel new paper What is a Monetary Standard. More on that in the coming days.

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If you want to hear me speak about these topics or other related topics don’t hesitate to contact my speaker agency Specialist Speakers – e-mail: daniel@specialistspeakers.com or roz@specialistspeakers.com.

2008 was a large negative demand shock – also in Canada

Scott Sumner has a follow-up post on Nick Rowe’s post about whether a supply shock or a demand shock caused the Canadian recession in 2008-9. Both Nick and Scott seem to think that the recession in some way was caused by a supply shock.

I must admit that I really don’t understand what Scott and Nick are saying. It is pretty clear to me that the shock in 2008-9 was negative aggregate demand shock.

Lets start with the textbook version of a negative aggregate demand (AD) shock). Here is how a negative demand shock looks in AS/AD model (the growth rate version):

Demand shock

So what happened in Canada? Here is a look at inflation measured by headline CPI and by the price deflator for final domestic sales.

CAD inflation

Both measures of inflation were running higher than the Bank of Canada’s official 2% inflation target when the crisis hit in the autumn of 2008.

However, it is pretty clear that inflation slowed sharply and dropped well-below the 2% inflation target in 2009 as the Canadian economy went into recession (real GDP contracted). It is hard to say that this is anything other than a rather large negative AD shock.

Obvioulsy inflation increased above 2% in 2011, but we all know that a major negative supply shock hit in 2011 as global oil prices spiked. In the case of Canada this in fact is both a negative supply shock and a positive demand shock (remember Canada is an oil exporter). That said, the rise in inflation was certainly not dramatic and since 2012 inflation has once again dropped well-below 2% indicating that monetary policy in Canada has become overly tight given the BoC’s 2% inflation target.

I might add that different measures of inflation expectations (both survey and market data) are telling the exact same story. Inflation and inflation expectations eased significantly in 2008-9 and once again in 2012.  

And we can tell the same story if we look at the price level. The graph below compares the two measures of prices (CPI and the final domestic demand deflator) with an 2% price path starting in Q3 2008.

Canada Price Level

Again the picture is clear. The price level – for both measures – are lower than a hypothetical 2% price level path – indicating that Mark Carney and his colleagues in the Bank of Canada have kept monetary conditions too tight over the past 4-5 years – maybe because of a preoccupation with the risk of “bubbles”. Mark Carney might be talking about NGDP level targeting, but he is certainly also speaking quite a bit about “macroprudential indicators” (modern central bank lingo for bubble risk).

Concluding, it is very clear that the Canadian economy was hit by a large negative demand shock in 2008 and initially the BoC has kept monetary policy overly tight and the recent tightening of monetary conditions certainly also looks problematic.

Once again it is monetary policy failure and it is certainly not a negative supply shock, which is to blame for the Canadian recession and sub-trend growth since 2008. Needless to say NGDP tells the exact same story. I should add that the size of this “monetary policy failure” is fairly small compared to for example for example what we have seen in the euro zone.

Reminding Scott about the Sumner Critique

Given the very clear evidence of a negative demand shock I find this comment from Scott somewhat puzzling:

Let’s suppose that the BOC had been targeting NGDP in 2008, when global trade fell off a cliff.  How would the Canadian economy have been affected?  Many would see the drop in global trade as a demand shock hitting Canada, as there would have been less demand for Canadian exports.  In fact, it would be an adverse supply shock.  Even if the BOC had been targeting NGDP, output would have probably fallen.  Factories in Ontario making transmissions for cars assembled in Ohio would have seen a drop in orders for transmissions.  That’s a real shock.  No (plausible) amount of price flexibility would move those transmissions during a recession.  If the assembly plant in Ohio stopped building cars, then they don’t want Canadian transmissions.  If the US stops building houses, then we don’t want Canadian lumber.  That’s a real shock to Canada, i.e. an AS shock.

I simply don’t understand Scott’s argument. A negative shock to exports obviously is a negative demand shock. From the perspective of nominal spending a negative shock to exports is a negative shock to money-velocity in the exact same way as a tightening of fiscal policy. Therefore, if the BoC had been targeting NGDP (it actually also goes for inflation targeting) the Sumner Critique would apply – the BoC would offset any negative shock to exports by easing monetary policy (increasing M to offset the drop in V). As a consequence domestic demand would rise and offset the drop in exports. And this obviously applies even if prices are sticky. Yes, the production of transmissions in Ontario drops, but that is offset by an increase in construction of apartments in Vancouver.

However, the point is that the BoC failed to offset the shock to exports and as a consequence prices have been growing slower than implied by BoC’s official inflation target.

There is absolutly nothing special about Canada – its monetary policy failure – the failure is just (a lot) smaller than in the euro zone or the US.

PS I could also have used the GDP deflator as well in my examples above. The story is the same. In fact it is worse! The GDP deflator dropped by more than 4% during 2009. The primary reason for the massive drop in the GDP deflator is that the price of oil measured in Canadian dollars dropped sharply in 2008-9. As drop in the oil price obviously is a negative demand shock as Canada is a oil exporter. The story in that sense is completely the same as what happened to the Russian economy in 2008-9. Had the BoC had followed a variation of an “Export Price Norm” as the Reserve Bank of Australia is doing then the negative shock would likely have been much smaller as was the case in Australia.

GDP deflator Canada

PPS JP Irving also comments on the Canadian story.

Bank of Canada is effectively targeting the price level

Last week the Bank of Canada and Canadian government announced – not overly surprising – that it will continue its 2% inflation targeting regime.

This is a slight disappointment to Market Monetarists, but that said maybe the BoC is not really having a inflation targeting. In fact research show that BoC effectively has been targeting the price level rather than inflation.

This at least is the conclusion in a IMF paper from 2008. Here is the abstract:

“One of the pioneers of inflation targeting (IT), the Bank of Canada is now considering a possibility of switching to price-level-path targeting (PLPT), where past deviations of inflation from the target would have to be offset in the future, bringing the price level back to a predetermined path. This paper draws attention to the fact that the price level in Canada has strayed little from the path implied by the two percent inflation target since its introduction in December 1994, and has tended to revert to that path after temporary deviations. Econometric analysis using Bayesian estimation suggests that a low probability can be assigned to explaining this behavior by sheer luck manifesting itself in mutually offsetting shocks. Much more plausible is the assumption that inflation expectations and interest rates are determined in a way that is consistent with an element of PLPT. This suggests that the difference between IT as it is actually practiced (or perceived) and PLPT may be less stark than what pure theoretical constructs posit, and that the transition to a full- fledged PLPT regime will likely be considerably easier than what was previously thought. The paper also shows that inflation expectations are a major driver of actual inflation in Canada, which makes it easier to keep inflation close to the target without large output costs.”

HT Jens Pedersen

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