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). 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. —- 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: email@example.com or firstname.lastname@example.org.