Wednesday, December 9, 2015

Negative Interest Rates, Eh?

David Parkinson and Barrie McKenna of the Globe and Mail report, Bank of Canada opens door to negative interest rates as oil, dollar sink:
The Bank of Canada has restocked its emergency kit to defend the Canadian economy against major shocks, including indicating that it would consider pushing interest rates as much as a half percentage point into negative territory in the event of a crisis.

But Governor Stephen Poloz stressed that the central bank’s new framework for using negative interest rates and other unconventional monetary policies, which he introduced in a speech Tuesday, does not mean the bank is preparing to use any of these measures – even as the country deals with the aftershocks of the collapse in the price of oil and other commodities.

“Today’s remarks should in no way be taken as a sign that we are planning to embark on these policies,” he told an Empire Club of Canada luncheon in downtown Toronto. “We don’t need unconventional policy tools now, and we don’t expect to use them. But it’s prudent to be prepared for every eventuality.”

The unveiling of the central bank’s new unconventional-policy framework comes after a week of distressing developments affecting Canada’s still-fragile economy. Oil prices plumbed six-year lows, sending the Canadian dollar to its lowest level against its U.S. counterpart in 11 years. Prices of other resource commodities also slumped, contributing to a 5-per-cent sell-off of the Toronto Stock Exchange in the past five trading days.

And all this is taking place just days before the powerful U.S. Federal Reserve looks likely to raise its key interest rate next week for the first time since before the Great Recession.

Most of the world’s central banks, including Canada’s, have been cutting rates. A Fed hike will mark a major divergence in global interest rates that is already sending tremors through the world’s stock, bond, commodity and currency markets.

Nonetheless, Mr. Poloz said Tuesday that he remains convinced that Canada’s economy remains on track for a continued recovery in 2016.

“I think we’ve got all the ingredients of a recovery in place,” he said in a news conference after the speech. “It’s being masked right now, to some degree, by the declines especially in the energy sector, but also in other resource areas.”

The Bank of Canada published new guidelines for using tools other than traditional interest rates – collectively known as unconventional monetary policy – to deal with economic crises at times when interest rates are near zero. The document updates a framework the bank introduced in April, 2009, as the global financial crisis still raged.

After years of persistently low interest rates not just in Canada but worldwide, and with economic trends pointing to a continuation of historically lower-than-normal rates for years to come, unconventional monetary tools have become increasingly common among the world’s central banks to stimulate economies. With the Bank of Canada having halved its own key rate to a historically thin 0.5 per cent after two rate cuts this year, it looked long overdue to address its guidelines on using unconventional measures.

“It’s been several years since we put them out. We knew they needed updating, based on our research and the experience in other countries,” Mr. Poloz said. “We’re making sure that our tool kit is up-to-date.”

The guidelines spell out several unconventional options the bank would consider, including large-scale asset purchases (known as quantitative easing), providing explicit statements about future policy intentions (forward guidance) and the funding of credit to specific sectors – all of which have proven to be effective, to varying degrees, in lowering market interest rates and providing economic stimulus. The Bank of Canada was a global pioneer in using forward guidance during the 2008-09 financial crisis, but unlike other central banks, it hasn’t tried any of the other unconventional tools it lays out in the guidelines.

Perhaps the most intriguing new wrinkle is the central bank’s calculation that the effective bottom (or “lower bound” in central-bank speak) for its interest rate is not zero, but rather negative-0.5 per cent. In its 2009 framework, it had considered 0.25 per cent to be its effective lower limit, which matches the record low of the bank’s key rate during the financial crisis.

But recently, a growing number of central banks, particularly in Europe, have resorted to negative interest rates – with no apparent ill effects. Just last week, The European Central Bank lowered the rate on its deposit facility to negative-0.3 per cent.

Commercial banks are willing to accept negative rates on their deposits with the central bank because there are considerable costs associated with the holding and storing of large volumes of currency – effectively, they are willing to pay central banks to hold it for them.

“This is a good change [that] they finally got around to acknowledging that they could go beyond zero,” said Carleton University economics professor Nicholas Rowe, who specializes in monetary policy. “What’s made it obvious is that so many other central banks are doing just that.”

It also implies that the current level of 0.5 per cent still leaves the bank with more room for additional cuts than many people had assumed.

“We now believe we have roughly 100 basis points worth of room underneath our current interest-rate setting,” Mr. Poloz told the news conference.

“This could be a signal that deflation is not a serious threat, because there are ways for monetary policy to keep up the fight,” McGill University economist Christopher Ragan said. He argued that this suggests there is no reason for the central bank to raise its current 2-per-cent inflation target – something the bank has been contemplating as it prepares for the renewal of its five-year inflation-targeting agreement with the federal government next year.

Still, Mr. Poloz insisted repeatedly Tuesday that the central bank doesn’t see any need to resort to negative interest rates, or any other unconventional policy tools, in the current economic environment – despite the latest battering of commodity prices and the Canadian currency.

Mr. Poloz insisted that the economy is still on track to return to full capacity “around mid-2017,” unchanged from the bank’s most recent economic forecast in October. He argued that the most recent reading of gross domestic product, which showed that the economy contracted by 0.5 per cent in September, was due to short-term “special factors,” most notably a fire that shut down most of the production at the huge Syncrude Canada Ltd. oil sands facility for the month.

“The overall economy is growing again, even as the resource sector contends with lower prices, because the non-resource sectors of the economy are gathering momentum,” he said in his speech.

He noted that the stimulative effects of the bank’s earlier rate cuts and the weaker Canadian dollar haven’t fully worked their way into the economy. On the rate cuts in particular, he said, the impacts “are still probably only half there. It will take another year for all those effects to come through.”

“We need to be a little bit patient here,” he said.

However, he also acknowledged one of the lessons of the post-crisis era is that monetary policy is less effective once interest rates reach ultra-low levels. “Fiscal policy tends to be a more powerful tool than monetary policy in such extreme circumstances,” he said.

The new Liberal government is vowing to spend billions on infrastructure projects to help kick-start the economy, and will go into deficit for at least two years to pay for it. That could take much of the pressure off the Bank of Canada to have to resort to negative interest rates and other unconventional policies.

“It’s not very likely if we have a federal government prepared to use fiscal stimulus if things get worse,” said Avery Shenfeld, chief economist at Canadian Imperial Bank of Commerce.
Pete Evans of CBC News also reports, Negative interest rates an option in Canada, Stephen Poloz says:
Canada could theoretically follow the lead of other countries that have recently gone to negative interest rates in order to stimulate the economy, central bank governor Stephen Poloz told a business audience today after yet another drop in the loonie.

Speaking to the Empire Club in Toronto, Poloz said moving its benchmark interest rates below zero is something in the Bank of Canada's monetary policy toolkit that the bank may consider down the line.

That's a departure from 2009, when the bank said its theoretical lowest-possible interest rate was 0.25 per cent because to go lower would have been incompatible with certain financial markets, such as money-market funds.

"The bank is now confident that Canadian financial markets could also function in a negative interest rate environment," Poloz said.

Poloz was speaking after the Canadian dollar today shed another half-cent from the previous day, dropping to a new 11-year low under 74 cents US.

But while Poloz opened the door to the possibility of negative interest rates, he stressed — in English and French — that the bank has no current intention to do so.

"Today's remarks should in no way be taken as a sign that we are planning to embark on these policies," Poloz said. "We don't need unconventional policies now, and we don't expect to use them. However, it's prudent to be prepared for every eventuality."

The Bank of Canada twice this year cut its benchmark interest rate in an attempt to stimulate the economy.

But other countries have gone even further, slashing their rates below zero in an attempt to encourage spending and investment, instead of fearfully hoarding capital.

Switzerland, Sweden, Denmark and the European Central Bank have all dipped their benchmark rate below zero for various reasons in recent years. Switzerland's central bank rate is now minus 0.75 per cent, for example. That means banks must pay a fee to store money with the central bank — something that encourages them to not do so, and deploy their capital into other investments that grow the economy.

"Why would anyone ever accept a negative nominal return when they could always simply hold cash and earn a zero return?" Poloz asked, rhetorically. "A big part of the answer is that there are costs to holding currency, particularly in large quantities, and these costs affect the lower bound. Because of the costs, which include storage, insurance and security, central banks can charge negative rates on commercial bank deposits without seeing a surge in demand for bank notes.

To put it simply, the Bank of Canada now thinks negative interest rates are a policy option in its tool belt because the experience of other countries that tried them wasn't calamitous. Negative rates, to varying degrees, achieved their goals without any undue negative consequences.

But that doesn't necessarily mean that Canadian consumers would actually see negative interest rates — a mortgage that pays you to hold it, for example — even if the central bank goes negative, Poloz said, citing examples of what happened in other countries' consumer lending markets once the central bank went below zero.

In those cases, commercial banks swallow the relatively small costs of the central bank's lending rate without ever directly passing it on to their own customers by charging fees to hold deposits.

"Interest rates don't go below zero for savers," Poloz said at a question-and-answer session following his speech, noting that in Switzerland and elsewhere, consumers still earn microscopic amounts on savings and pay tiny interest rates on consumer loans. "We would expect the same sort of behaviour here," he said.

"We now believe that the effective lower bound for Canada's policy rate is around minus 0.5 per cent, but it could be a little higher or lower," Poloz said.

But negative interest rates weren't the only central banking tools that Poloz discussed in Tuesday's speech.

Poloz announced another new unconventional measure added to the bank's arsenal: Funding for credit.

The option would ensure economically important sectors had continued access to funding even when the credit supply is impaired, Poloz said. That's exactly what happened in 2009 when the Canada Mortgage and Housing Corporation (CMHC) took mortgages off the books of Canada's big banks to free up cash for them to lend money to deserving borrowers.

"This program was clearly aimed at one market segment that was at risk of impairment and so had a similar purpose to funding for credit," Poloz said.

Poloz also said fiscal stimulus tends to be a more powerful tool than monetary policy in extreme crises.

All in all, Poloz reiterated his optimism for the Canadian economy and reaffirmed his projection it was strengthening despite the pain of persistently low resource prices. The non-resource sectors, Poloz added, have continued to strengthen.

"We will continue to watch how these policies work in other economies and adjust our own thinking at the Bank of Canada as appropriate," Poloz said. "In short, should the need arise, we'll be ready."
I've said it before and I'll say it again, we are very lucky to have Stephen Poloz as our central banker. I worked with Steve at BCA Research, know him well enough to know he's a very smart economist who understands the bigger global picture.

What are my thoughts on the Canadian economy? I told my blog readers to short Canada exactly two years ago and explicitly stated to short the overvalued loonie back then fearing that oil and commodity prices were going to drop a lot more (the loonie is a petro currency, period).

Exactly one year ago, I wrote that Canada's crisis is just beginning stating that Steve Poloz is right  to worry about deflation because if takes hold in Canada with household debt at a record high, it will get ugly for years, maybe even decades.

If you want to really see how bad things are in Canada go talk to restaurateurs, taxi drivers, small business owners which are suffering in droves. Just last night, I went with my buddy to grab a cheeseburger, fries and wine at Nouveau Palais.

The place is an old diner off of Avenue du Parc that used to be owned by Greeks. The French Canadian owners kept the old decor, changed the menu, added music and serve alcohol. Great little place that young Grungies love to hang out in. I love it because once in a blue moon when I want to deviate from my healthy Mediterranean diet and gorge on a juicy cheeseburger with fries and wine, this is the place for me (it has the best cheeseburger in the city; the one at DeVille is a close second).

Anyways, my buddy and I talked to Jacques, the owner/ manager of the place and I told him I was surprised to see how many stores are closing in the neighborhood. He told us that business is down across the board, the cost of hamburger meat has skyrocketed in the last few years and the city of Montreal is raising taxes on small businesses, all of which are squeezing profits because "you can't pass those costs on to consumers" (it also doesn't help that the Quebec government has black boxes in restaurants and pretty soon bars to make sure there's no tax evasion going on. It's only a matter of time before this gets introduced in Ontario).

The bottom line is things are not going well in Canada because most people are over-indebted, worried about losing their job and paying off their mortgage on their insanely over-valued house or just paying off credit card debts. They simply don't have the disposable income they once had to dine out every other day and spend money like they used to.

And this isn't just a Montreal problem although Quebecers are much poorer than Ontarians or people out in British Columbia. There's a real problem in Canada and it's obvious the worst hit province right now is Alberta where the suicide rate has jumped significantly in the first half of 2015.

[Note: Be careful interpreting these statistics. My father, a psychiatrist with over 40 years of clinical experience, tells me although financial distress can contribute to rising suicides the truth is "suicide is extremely complicated" and that depression is a lot more common than people think. Thankfully, only a very small percentage of depressed people take their own life because in most cases, depression can be easily treated with proper medical care and follow-up treatment.]

Back to the Bank of Canada and negative rates. What do they mean? The Globe and Mail's Rachelle Younglai covers the impact on banks, consumers and the economy here. Is it possible the Bank of Canada resorts to negative rates? You bet it is and I wouldn't be surprised if the Bank is forced to take aggressive measures in the future which include buying federal, provincial and corporate bonds, mortgage-backed securities and even stocks (all part of quantitative easing or large scale asset purchases), funding for credit or negative rates. These unconventional monetary policy measures are what all central banks are doing as they're trying to save the world from a prolonged period of debt deflation.

All central banks are in easing mode except for the Fed which is now preparing to hike rates in December in what might prove to be the greatest policy blunder of our time, especially if the surging greenback keeps rising and U.S. import prices keep falling.

I know, there are smart economists like Martin Feldstein who think that U.S. inflation pressures are picking up steam and that the Fed will be forced to raise rates more aggressively in 2016. Then there's Jeffrey Gundlach, the reigning bond king, who just posted a sober presentation entitled "Tick, Tick, Tick..." which presents a scary picture of what will happen if the Fed raises rates (click here to view it).

I don't know, think Mario Draghi offered Janet Yellen a gift last week allowing the Fed to raise rates next week as the euro has strengthened a bit, but this might turn out to be a bomb wrapped up in a gift box. If Gundlach is right, the Fed will be forced to reverse course in 2017 and that's when things get interesting and frightening as the Martingale casinos go for bust.

We shall see but one thing is for sure, things are not going well in Canada. I hope Governor Poloz is right and the effects of a lower loonie will eventually seep through the economy. I hope that Justin Trudeau's Liberals are able to pass major infrastructure projects very soon but I fear that Canada's crisis will continue and all these measures might help at the margin but will not prevent the ongoing carnage in our economy (trust me, I hope I'm wrong but fear the worst lies ahead, especially once Canada's housing bubble bursts).

Lastly, take the time to read Ted Carmichael's latest, Recession: A Made-in-Canada Definition. Ted doesn't blog a lot but I enjoy reading his comments just like I enjoy reading those of Brian Romanchuk, my former colleague at BCA Research and then the Caisse (see his latest on the Bank of Canada's Unconventional Monetary Policy as well as his last comment, Let The Fed Policy Error Debate Begin, which is more sanguine than Gundlach's dire presentation).

You're all very lucky to have people like Ted, Brian and me providing you with free thought provoking insights. Very lucky!!

On that note, please remember to subscribe to this blog on the top right-hand side and support my efforts in bringing you unique insights on pensions and investments. You will also notice that I now allow funds to post informative guest comments on my blog to provide their unique insights on markets. All I ask is that they donate or just subscribe to the blog which is read by the who's who of the global pension and investment industry.

Below, Bank of Canada Governor Stephen Poloz speaks before the Empire Club of Canada on The Evolution of Unconventional Monetary Policy. You can read his entire speech on the bank's site here.

Like I said, we Canadians are very lucky Stephen Poloz is at the helm of our central bank. Hope he's right that this is a cyclical downturn not "secular stagnation" but I'm a lot more concerned about what lies ahead, especially if deflation eventually comes to America. If that happens, expect negative rates in Canada, Europe, Japan and the U.S. to persist for a long, long time. Wouldn't that be something, eh?

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