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.

The ZLB – not the BoJ – should worry the BoK

The continued sharp weakening of the Japanese yen is beginning to worry policy makers (and commentators) in South East Asian and that is especially the case in South Korea. Just see this comment from Andy Mukherjee over at Reuters Breakingviews:

Japan’s weak yen policy could be South Korea’s biggest economic enemy this year. The strengthening won, which has risen 23 percent against the yen in the past six months, was partly to blame for the country’s anaemic GDP growth in the fourth quarter. It’s also putting the squeeze on manufacturers like Hyundai. Lower interest rates could help to ease the pressure.

An appreciating currency is a big dilemma for South Korea’s central bank. Investors are betting the Bank of Korea’s policy interest rate of 2.75 percent, which it last reduced in October, will remain unchanged as the incoming government of President Park Geun-hye boosts public spending in an attempt to revive growth.

But the wait-and-watch approach is risky because it could engender expectations that the central bank is not particularly worried about the country’s exports losing some of their price competitiveness.

With the likes of Hyundai and Samsung competing directly against Japan’s Honda and Sony, a cheaper yen will undermine the profitability of Korean exporters. The surprise 6 percent drop in Hyundai Motor Co’s net profit in the final quarter of 2012 underscores the risk. And now that the Bank of Japan has agreed to support Prime Minister Shinzo Abe’s plan by printing 13 trillion yen ($145 billion) in new money every month starting in January 2014, the yen could weaken further.

There is nothing wrong with Andy’s observations as such. It is obvious that Korean and Japanese eletronic and cars producers are major competitors in the global markets and Korean exporters are likely suffering relative to Japanese exporters. That said Andy’s comments smells of currency war-rhetoric, which always worries me.

In that regard I will make two observations. First, the aggressive change in monetary stance from the Bank of Japan is likely to give a major boost to the second (or third) largest economy in the world and is therefore likely to be good news for the global economy and particularly for the Asian economies. That certainly will help Korean exporters. Second – as I have argued in the case of Mexico – no country is forced to import monetary easing or tightening. Hence, the Bank of Korea (BoK) is completely free to conduct monetary policy in way to serve the interest of the Korean economy. If the BoK don’t like the strengthening of the won it can simply counteract it with monetary easing in the form of interest rate cuts, quantitative easing or intervention in the currency markets. Hence, in my view the BoK can alway “neutralize” any impact on the Korean economy from the strengthening of the won.

Disregarding “currency war” monetary easing is nonetheless warranted

The continued strengthening of the won obviously is a sign that Korean monetary conditions are tightening and judging from recent economic data the tightening of monetary conditions certainly is not welcomed news – rather monetary easing is warranted. However, the reason is not really the performane of Korean exports – in fact the Korean export performance has been quite strong in recent years and export growth actually remains fairly high. Contrary to this domestic demand has been slowing and especially investment growth is weak.

So once again I think it is useful to see the currency as an indicator of monetary policy “tightness” rather than a cause of the problems in itself. The strengthening of the won is a clear sign that Korean monetary conditions are getting tighter. But the worry is not really on the export side of the economy – even though I readily admit that Korean exporters are suffering at the moment – but the real worry is the slowing domestic demand. The graph below illustrates that.

korea exconsinv

Obviously central banks should  not concern themselves with the composition of growth , but that of course do not mean that the BoK should worry at all.

As Andy notes:

With inflation slowing to just 1.4 percent in December, much lower than the central bank’s target range of 2.5 percent to 3.5 percent, the monetary authority certainly has the scope to reduce interest rates. The Bank of Korea should grab the lacklustre GDP figures as an opportunity to give the economy another monetary boost.

So judging from BoK’s own inflation target monetary easing seems warranted. The story is the same if we take a look at the ultimate Market Monetarist benchmark – the development in nominal GDP in South Korea.

NGDP korea

The graph is pretty clear – the BoK more or less managed to bring back NGDP to the pre-crisis trend level 2009-10, but since 2011 NGDP has been “softening”, which clearly indicates that monetary easing is needed.

Beware of the Zero Lower Bound!

With the BoK’s key policy interest rate at 2.75% there is still room for use it’s “normal” monetary policy instrument to ease monetary policy. That said, in an environment where the won is strengthening significantly the BoK first needs to “neutralize” the effect of this strengthening with rate cuts and then additionally needs to ease “on top” of that to push NGDP back on track.

That could in a negative scenario easily bring the BoK’s key policy rate down close to zero. Just imagine a new escalation of the euro crisis or a new financial shock of some kind.

In such a scenario the BoK would be unable to ease monetary policy further through interest rate cuts as interest rates effective would hit the the zero lower bound (ZLB).

While we are someway away from the ZLB in Korea it is also clear that the risk of hitting it should not be ignored. In fact I believe that the zero lower bound should be a bigger worry for the BoK than the BoJ’s monetary easing.

Luckily the BoK can do something about it. The most simple thing to do is simply to pre-announce what policy instrument it will resort to in the event that interest rates where to get too close to zero. A possibility is simply to state that if interest rates hit zero then the BoK will switch to a Singapore style monetary policy, where the central bank conduct monetary policy through the exchange rate channel.

A pre-announcement of this sort would likely avoid bringing the BoK in a situation where it actually would have to intervene in the FX market as the markets expectations of FX intervention would on it own lead to a weakening of the won. This effectively would be what I have called McCallum’s MC rule.

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