Bank of Canada: Back to the Future?

Paul Gambles

By Paul Gambles

Just as major central banks are finally beginning to withdraw their post-GFC policies, the Bank of Canada may be considering a complete volte-face.

Since late 2008, the central banks of many of the world’s largest economies have been implementing emergency measures in an attempt to get consumption back to pre-crisis levels (it says a lot that a central bank emergency measure can last for over 10 years – in the same way that Income Tax was introduced in the UK in 1842, at the time when Upper Canada was being superseded by the United Province of Canada, as a temporary measure but has never been repealed).

These emergency measures centred on low base interest rates and a bond buying scheme called quantitative easing (QE). The US Federal Reserve’s 2008-2014 QE program alone cost somewhere in the region of US$4.5 trillion.

While the Bank of Canada never adopted a full-scale QE policy, it did drop its base rates rapidly in 2008 and early 2009 – when it lowered them as far as 0.25% in April 2009. Since then, the Bank has raised them to 1%, lowered them to 0.5% and, last September, brought them back to 1%.

Donald Trump’s new import tax laws could reverse this “trend”. According to Deutsche Bank, they could have a huge negative impact on Canada’s economy if Canadian goods become too expensive for Americans to buy. If this happens, Stephen Poloz and his colleagues may well consider dropping those rates again and even introducing QE.

If we have learned anything from the past decade, though, it is that QE and ultra-low interest rates just don’t work.

The theory went that, in a depressed economy where consumption is low, reducing the cost of funding for commercial banks would encourage them to pass on that saving by reducing lending costs for companies and individuals.

Low interest rates on lending would thus encourage people and businesses to spend more on credit. Once consumption picked up, the central bank would raise interest rates so commercial banks would again follow suit, to stop the economy from overheating through high inflation.

Has it worked? Well, the fact that, a decade on, central banks are only just moving away from the policy tells us a lot. Taking a statistical approach, levels of consumption to GDP in countries such as the US and the UK also show that the economy is still worse off than just before the global financial crisis and has barely moved on from the immediate post-shock period. While Canada’s consumption to GDP rate has actually been consistently higher post-GFC than in the ten years before it, that’s because Canadian gross domestic product plummeted and remained low from 2009 onward.

Admitting that ten years of “temporary” interest rates and a poorly-adapted version of Professor Richard Werner’s QE strategy have been a significant waste of time and money appears to be a difficult pill to swallow for the politically-appointed heads of central banks. Instead, they’ve decided to pretend the tools they’ve been using have now done their job and it’s time to move on.

The Bank of England, for example, recently said that it had increased its rate to curb inflation, which has just charted its eighth consecutive month rising above the 2% target – in September this year, it hit 3% year-on-year. Considering the UK had previously spent three years under target (including some months of deflation), I’d say its economy needed some reasonable price increases to help raise salaries, making it easier for people to pay off all that private debt. Added to that, the Bank of England, run by Canadian export, George Clooney lookalike, Goldman Sachs alum and ex BoC Governor Mark Carney, could hardly claim a booming economy as justification to increase rates as the inflation appears to be driven more by the protracted period of post-referendum Sterling weakness (increasing the cost of imports) than by anything more constructive.

Yet the Bank of England’s actions seem perfectly sane compared to the justifications given by the US Federal Reserve’s FOMC. In June, on explaining the Fed’s third interest rate increase in six months, Chairwoman Janet Yellen said the move reflected the “progress the economy has made and is expected to make towards the maximum employment and price stability objectives assigned to us by law.” But before the Fed’s first raise in over a decade, last December, inflation had been below the Fed’s 2% target for over three years. Then, having increased rates, inflation jumped up to 2.7% in February before dropping below target.

Not only that, the Fed’s other stated target – employment – is far from being healthy, given the huge drop the US experienced in 2009.

Like the US and UK, Canada’s inflation rate has behaved in complete isolation. As the Bank of Canada has gradually increased the base interest rate, inflation should theoretically drop. However, year-on-year rates in 2017 have decreased from 2.13% in January to 1.01% in June, but hit 1.55% in September. October’s y-o-y rate was 1.39%.

What we’re seeing then, is central banks pretending to be in control, when they’re in fact just muddling along. In a seminal paper, the Bank of England has even admitted that it can’t “directly control the quantity of either base or broad money” and at best can only influence this, but that monetary policy becomes less effective, even as an influence, the closer rates get to zero.

The direct individual impact on savers and borrowers may not be great but raising rates and tightening fiscal policy at this time may be just as great an experiment and an even greater mistake than negative or zero-interest-rate policies have proven to be. In the late 1920s central banks experimented with policy at that time – the French national bank dramatically reducing the circulation of money by buying additional gold reserves to support the value of the Franc. I think that we all know how that ended – The Wall Street Crash, The Great Depression and WW2. History doesn’t necessarily repeat but pursuing the same types of policies and expecting different outcomes is a special kind of madness, central bank madness.

If the Bank of Canada does implement QE and keeps interest rates low, it will be in the face of a decade of evidence. What Canada and the rest of the world needs right now is a sanity check!

Paul Gambles is co-founder of MBMG Group

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