Oh. Snap. Canada’s central bank just threw monetary policy shade at the Government of Canada. The Bank of Canada (BoC) just released a new study called The Central Bank Strikes Back! Credibility of Monetary Policy under Fiscal Influence. In it, they examine how a central bank should react when pressured by the government. They argue massive government debt is eroding their ability to execute inflation control. To maintain credibility, they suggest a strategic framework that provides conditional support.
Monetary Dominance: What Is It, And Why Is It Important?
Central banks like the BoC have one job and one job only — to control inflation by influencing the value of money. It’s not a debate. It’s the first thing they write on their website. For central banks to execute this goal, they require monetary dominance.
Monetary dominance is when the central bank focuses just on its goal to control inflation. They completely ignore fiscal authority (Government) to do so.
“However, rising levels of public debt have triggered mounting political pressure and government interference with central banks,” warns the central bank staff.
Basically, Governments are pressuring central banks into facilitating their own goal. By ceding control, the central bank loses its ability to control inflation and the value of money. It’s called fiscal dominance when this happens, and the value of money is no longer the primary issue. It’s providing as much money as the Government needs at non-market interest rates.
Earlier this week, we discussed some of the issues with persistent and low interest rates. The BoC explains low (non-market) rates for too long, resulting in serious social distortions. It produces rising inequality, over-inflated assets, and a point we hammer — it inflates real estate prices. The BoC knows this even if the Governor won’t acknowledge it.
Monetary Dominance and Interest Rates
To understand how the BoC lost monetary dominance, let’s do a 10,000 ft view of interest rates. A central bank’s primary tool to create inflation is the interest rate. Lower it to make more inflation and execute on your goal. They need to incentivize loans to create demand for goods to inflate prices at the target rate. Still with me? Great.
The issue is credit is subject to the same supply and demand pressures of the asset prices inflated. Too much credit demand for supply and the cost of interest rises for similar loans. This increases bond yields, which throws a kink in the central bank’s plan. Their goal is to keep interest costs low to stimulate demand, so rising rates are a problem. They need a tool like quantitative ease (QE) when this happens.
QE is a program where the BoC buys government bonds competitively, bidding up their value. This creates lower yields, making credit of similar terms cheaper to borrow. By doing this they are stimulating demand for goods like homes, creating inflation.
In other words, to keep borrowing costs low when demand rises, they flood the system with money. That’s not an exaggeration, but how a US Federal Reserve President explained QE in 2020.
Governments Can Derail Monetary Dominance
What happens if the government borrows an astronomical amount of debt? The central bank needs to absorb it to keep rates low, leading to larger and longer purchases. National Bank of Canada (NBF) found the BoC bought the equivalent of 95% of newly issued government debt at one point last year. The central bank-owned $360.8 billion in GoC bonds at the time, roughly 40% of outstanding loans. Before 2020, the BoC only held 13% of outstanding GoC bonds.
Even if the BoC wanted to maintain inflation (and it’s unclear if they do), they can’t due to the volume of debt. It doesn’t just influence their borrowing rates though, it lowers all borrowing rates. It’s safe to say large borrowing was needed during a public health crisis. It’s naive to conclude excess borrowing didn’t occur due to a lack of scrutiny.
Parliament’s budget officer found a third of the pandemic spending was not for pandemic issues. If the public wants the Government to borrow for non-emergency funds, that’s fair. However, there are monetary consequences for using emergency rates to do it.
Some argue governments should borrow when debt is cheap. It’s like free money if the interest costs are below the inflation rate, right? It’s not always the rule. Inflation can be high because the Government is borrowing so much. They saved a point of interest, while your cost of living is at least 3 points higher? Maybe just let the Government pay the market rate of interest.
BoC Researches Suggest Placing Limits On Government Influence
The study is literally called “The Central Bank Strikes Back!” They obviously see this as a problem, but the authors accept it’s a problem they need to deal with. The ideal solution is to have politicians not use emergency facilities if they’re not needed. Once we accept the ideal solution won’t happen, we get the BoC study. They suggest the design and adoption of conditional monetary policy for future instances.
The study’s models suggest strategic monetary rules that include fiscal conditionality and improves outcomes. If the central bank continues to target inflation and deliver [X commitment], the Government should provide [Y commitment]. A credible commitment from the central bank can be keeping the money growth constant. A commitment from the Government might be balancing their budget over a medium term. Not letting revenues grow until it’s balanced, but actually balancing it.
To put it more bluntly, they each give each other something they want. This helps to prevent downloading blame onto the other party. It also helps both parties preserve their credibility, since restraint is built in.
The BoC study doesn’t make a direct reference to the Government of Canada. Direct criticism of the Government would be political, and they maintain that distance. However, this joins some other interesting studies that made us ponder. A study on whether or not telling people a bubble exists makes it worse, is an interesting example. Does it feel like a cry for help? Mint two loonies if you’re creating credit growth against your will, Governor.