Canadian Monetary Policy Research Articles

Using functional shocks to assess conventional and unconventional monetary policy in Canada

AbstractWe develop a new series of Canadian monetary policy shocks for the time period 1986 to 2023. Our shocks are constructed as the daily change in the Nelson–Siegel yield curve factors on days of monetary policy events such as announcements of the short‐run policy rate and speeches by Bank of Canada officials. This allows us to look at both conventional and unconventional monetary policy. We find that tighter monetary policy lowers inflation and GDP. Monetary policy shocks, however, often twist the yield curve, potentially offsetting changes in the short‐run policy rate. Finally, speeches also tend to move the yield curve with similar effects on inflation and GDP as formal policy announcements.

Effect of conventional and unconventional monetary policy shocks on housing prices in Canada

This paper investigates the relative importance and effect of conventional and unconventional Canadian monetary policy surprises on housing prices. Using a credible approach to identify structural monetary policy shocks in Canada and a comprehensive Bayesian VAR model to analyze their effects on financial and macroeconomic variables, we find that both conventional monetary policy and quantitative easing shocks have a significant and persistent effect on housing prices in Canada. However, the inflationary effect of a quantitative easing shock is more pronounced than that of an easing target monetary policy surprise. Specifically, the peak effect of a 25-basis point expansionary conventional monetary policy shock is a 2.30% increase in real housing prices while a comparable quantitative easing surprise leads to a peak of 4.56% increase in real housing prices. We conclude that expansionary monetary policy in various forms has had significant inflationary effects on Canadian housing prices. But quantitative easing surprises stand out as the most prominent contributory factor to the escalating Canadian real estate price. Quantitative easing impact consistently outweighs the effects of forward guidance and conventional monetary policy shocks.

Canadian Monetary Policy in the Time of COVID-19

Canadian Monetary Policy in the Time of COVID-19

Estimating the demand for settlement balances in the Canadian Large Value Transfer System: How much is too much?

AbstractThis paper applies a static model of an interest rate corridor to the Canadian data and estimates the aggregate demand for central bank settlement balances in the Large Value Transfer System (LVTS). The analysis takes into account the downward divergence of the overnight interest rate from the target rate, which has been persistent since 2005. The results suggest that a target of $3,000,000,000 for LVTS settlement balances does not seem excessive during the time period when Canadian monetary policy was operating at the effective lower bound (ELB). In addition, the estimation shows that the point elasticity of overnight interest rate is around 0.17 in the ELB framework.

A System with Zero Reserves and with Clearing Outside of the Central Bank: The Canadian Case

ABSTRACTIn a number of ways, implementing monetary policy in Canada stands apart from monetary policy in most other industrial countries. Commercial banks and other participants to the main clearinghouse – the large-value transfer system (LVTS) – hold no reserves at the central bank. Clearing and settlement is both in real time and net, while only settlement occurs on the books of the central bank. The Bank of Canada does not conduct open-market operations and rarely intervenes in the repo market; and despite this, the collateralized overnight rate always remains within 2 or 3 basis points of the target interest rate. The paper explains why this is so by describing the setup of the Canadian clearing and settlement system, including the rules that have been put forward in case a bank defaults on its due payments before settlement occurs. Some puzzles that arose through the years are also discussed, as well as the unlikely prospect of introducing blockchain technology in the Canadian clearing and settlement system.

International monetary policy transmission through banks in small open economies

This paper studies the international transmission of monetary policy through banks in small open economies using the examples of Switzerland and Canada. We assess the inward transmission of foreign monetary policy for Switzerland and the outward transmission of domestic monetary policy for Canada. In both country cases, we focus on the international bank lending and the international portfolio channel, which make opposing predictions about how monetary policy transmits internationally through banks. Our results on the inward transmission of foreign monetary policy through banks in Switzerland are consistent with a role for the international portfolio channel, but we find no evidence for the traditional international bank lending channel. The results on the outward transmission of domestic monetary policy in Canada suggest that foreign lending by Canadian banks is affected through both channels, which work as predicted and largely balance each other.

Monetary Policy Behaviour over the Long Run in a Small Open Economy: A Markov-Switching Vector Error-Correction Approach

This study identifies a long-run equilibrium relationship among important information variables with stochastic trends for monetary policy in Canada. The variables serve as both target policy variables for the domestic macroeconomy and reaction variables to external economic disturbances. The parameters of the cointegrated vector of information variables are found to be quite stable. A Markov-switching cointegrated VAR model captures two stochastic policy regimes with low- and high-variances. The weighting matrix for the error-correction terms for both inflation and output are found to be relatively stable across regimes, while the monetary policy rate is found to exhibit asymmetric behavior with error-correction adjustment only in the current low-variance regime.

Changes in monetary regimes and the identification of monetary policy shocks: Narrative evidence from Canada

Using narrative evidence with a novel database of real-time data and forecasts from the Bank of Canada’s staff projections (1974–2015), we construct a new measure of monetary policy shocks and estimate the effects of monetary policy in Canada. We show it is crucial to account for the break in the conduct of monetary policy caused by the announcement of inflation targeting in 1991. A 100-basis-point increase in our new shock series leads to a 1.0 percent peak decrease in real GDP and a 0.5 percent fall in the price level, while not accounting for the break leads to a persistent decrease in GDP and a price puzzle. Albeit the change in monetary regime, the effects of monetary policy have not changed much before and after IT.

Faulty Transmissions: Howe Demographics Affect Monetary Policy in Canada

Over the past decade, inflation in many countries has been tepid, despite rock-bottom interest rates and different forms of unconventional stimulative monetary policy, including quantitative easing. For its part, Canada has averaged 1.5 percent inflation over this period, below the 2 percent target. This Commentary asks what role demographics, in particular an aging population, has on monetary policy effectiveness, looked at through the lens of its impact on inflation and unemployment. This Commentary first evaluates the impact of Canadian monetary policy effectiveness on economic variables from the mid-1980s onward and then looks at the impact of an aging population on this effectiveness in the years since the Bank of Canada became an inflation-targeting central bank. We improve on previous work on Canadian monetary policy effectiveness by using monetary policy shocks that remove the puzzling results found in standard empirical setups. Furthermore, since the old-age dependency ratio changes only slowly over time, we use a panel data set that gives us the necessary variation. This allows us to estimate the impact of aging in Canada more precisely. Results are ambiguous on monetary policy’s effectiveness over the last 30 years. In part, this could be due to the fact that inflation expectations have become better anchored at the 2 percent target. This would mean that even if the Bank has to work harder to affect inflation, inflation is at least more stable in the face of real economic shocks. Our follow-up question – and, really, the central question of this Commentary – is what is the impact of demographics on this record of monetary policy effectiveness? What we find is that Canada’s aging population has acted as a drag on and is likely a leading cause of the systematic undershooting of inflation we have seen since the financial crisis. We also find that the interest rate and credit channels help explain this result. Specifically, an aging population that takes on less debt is less sensitive to changes in the interest rate. This means that meeting the Bank of Canada’s inflation target will require more significant changes to the overnight rate target and, in the case of expansionary monetary policy, will be made more difficult by a lower neutral rate of interest, which may result in a quicker move to unconventional monetary policy. The results in this Commentary should help the Bank of Canada adjust its analysis accordingly.

Navigating Turbulence: Canadian Monetary Policy Since 2004

The Bank of Canada should restore the important role of tracking the money supply as a predictor of future inflation and economic performance, according to a major new book on the conduct of monetary policy from the C.D. Howe Institute. In “Navigating Turbulence: Canadian Monetary Policy Since 2004,” authors Steve Ambler and Jeremy Kronick assess the BoC’s policies from 2004, through the turbulence of the 2008/09 recession, the recovery and up to the current period. Overall, they give the Bank high marks for its stewardship. However, the Bank faces key new challenges posed by the current low-interest-rate, low-inflation environment that require response, according to the authors.

The role of the exchange rate in Canadian monetary policy: evidence from a TVP-BVAR model

A time-varying parameters Bayesian structural vector autoregression (TVP-BVAR) model with stochastic volatility is employed to characterize the monetary policy stance of the Bank of Canada (BoC) in terms of an interest rate rule linking the policy rate to the output gap, inflation and the exchange rate. Using quarterly bilateral Canadian–US data, we find such an interest rate rule to have little explanatory power for the early part of our sample starting in the mid-1980s, but to become more suitable to explain interest rate dynamics from the mid-1990s onwards. Whereas the exchange rate turns out to be the major determinant of the policy rate in the 1980s, its importance declines throughout the 1990s and 2000s, although it continues to be influential even towards the end of the sample period ending in 2015Q2. We also find interest rate shocks to have become more effective in influencing the macroeconomy over time, indicating that the BoC has continually gained monetary policy credibility. We associate this development with the BoC successively de-emphasizing the role of the exchange rate in informing interest rate decisions, thereby alleviating the potential monetary policy conflict between targeting the exchange rate and maintaining the price stability goal.

Macroeconomic Switching Regimes and Monetary Policy in Canada

This study examines the behaviour of monetary policy in Canada over the last 40 years using a Markov-switching VAR model of the macroeconomy. The Markov-switching estimates capture three continuous regimes that are interpreted as the ‘surprise’ regime from 1972Q1 to 1982Q2, the ‘recovery’ regime from 1982Q3 to 1991Q3 and the ‘target’ regime from 1991Q4 to 2014Q4. Monetary policy multipliers for the output gap are greater than one for all three regimes, suggesting that the central bank does not accommodate any expected changes in inflation over the long-run due to the domestic relationship between the output gap and future inflation. The long-run multipliers for inflation are equal to one in the surprise and recovery regimes, indicating that monetary policy also responds to offset inflation shocks. Overall, the policy multipliers and impulse response functions indicate a proactive central bank that responds systematically to movements in the output gap in order to control expected future inflation and to inflation surprises in the three regimes. The regime-dependent behaviour of monetary policy indicates a central bank pursuing an implicit form of inflation targeting as a means of achieving a nominal anchor for policy. The implicit inflation tar­gets are consistent with historical episodes of inflation in Canada over the past 40 years.

The Politics of Canadian Monetary Policy: Reassessing Canadian Inflation, Part II

:This is the second installment of a two-part article on Canadian inflation. This article builds on the traditional conflict theory of inflation by applying insights from the post-Keynesian and micro-politics theories of money and central bank policy. It argues that the Bank of Canada’s inflation targets — not just inflation itself — have to be understood in terms of social conflict and power. This analysis extends the evidence on the distributive implications of Canadian inflation offered in Part I.

The Monetary Transmission Mechanism and Inflation Targeting: A Regime-Switching VAR Approach for Canada

This study employs a Markov-switching VAR with regime-dependent dynamics to assess the trans­mission mechanism of monetary policy in Canada. The regime-switching estimations divide the sam­ple period stochastically into two continuous regimes that corresponds to the periods before and after explicit-inflation targeting in Canada. The empirical results indicate relatively large differences in both the innovation process due to the variance component of the VAR and the propagation mech­anism due to the regime-dependent systematic component. The pre-targeting regime corresponds to much larger innovations in the macroeconomic variables and overall larger systematic responses of the macroeconomic variables to the innovation processes, suggesting a stronger monetary transmis­sion mechanism in the regime. However, variance decompositions and counterfactual analysis sug­gest that monetary policy has become more responsive to fluctuations in output growth and inflation in the target regime. Overall, about 80 per cent of the variations in the monetary policy rate in the current regime can be explained by the systematic reactions of policy to output growth and inflation at the relevant policy horizons.

Canadian monetary policy analysis using a structural VARMA model

AbstractThis paper builds a structural VARMA (SVARMA) model for investigating Canadian monetary policy. Using the scalar component methodology proposed by Athanasopoulos and Vahid (2008a), we first identify a VARMA model and then construct a SVARMA for Canadian monetary policy. Relative to the responses by a structural VAR, the responses generated by the SVARMA are consistent with those supported by various theoretical models and solve economic puzzles commonly found in the empirical literature on monetary policy. The superior out‐of‐sample forecasting performance of the reduced form VARMA compared to VAR alternatives further advocates the suitability of this framework for small open economies.

Securing Monetary and Financial Stability: Why Canada Needs a Macroprudential Policy Framework

Canada’s inflation-target agreement between the government and the Bank of Canada is up for renewal by 31 December 2016. In the aftermath of the 2008-2009 global financial crisis, one of the critical issues for consideration is the integration of price and financial stability in the conduct of policy. This Commentary addresses the importance for the conduct of monetary policy of having a separate coherent framework for macroprudential policy – designed to prevent the build-up of systemic, or system-wide, financial risks. A key lesson of the financial crisis was the insufficient attention being paid to these risks and their consequences for the economy. The importance of this issue can be seen in two ways. The first relates to the interactions between monetary and macroprudential policy tools in light of concerns about rising levels of household debt. At various times, there will be situations when only one policy tool is needed, when both policies need to be used in the same direction, or when the two policies need to work in opposite directions. The second relates to the Bank’s current “risk management approach” to monetary policy. In the absence of a government framework for the active use of macroprudential tools, this approach implies that monetary policy becomes a more important line of defence against systemic risks than it needs to be, with the risk of sub-optimal monetary policy outcomes. Our conclusions are threefold: • Canada’s 2 percent inflation target and policy framework has served the economy well, most importantly in anchoring inflation expectations; • over the past two years, Canadian monetary policy would have been better placed to combat low inflation and excess capacity had macroprudential policies been openly geared to reducing the systemic risks associated with rising household indebtedness and housing prices; and • drawing on best practices, the government needs to elevate macroprudential policies by establishing clear objectives, tools and lines of responsibility and accountability. The payoff for Canadians cannot be overstated: greater assurance of both financial stability, as a result of assigned responsibility for macroprudential policy, and monetary stability, as a result of the Bank of Canada’s continued primary focus on inflation and output stabilization.

Good Governance of Monetary Policy in Canada: Lessons from the C.D. Howe Institute's Shadow Council

The Bank of Canada should consider publicly disclosing the discussions and dissenting opinions of members of its interest-rate-setting committee, according to a new C.D. Howe Institute report. In “Good Governance of Monetary Policy in Canada: Lessons from the C.D. Howe Institute’s Shadow Council,” authors Pierre Siklos and Matthias Neuenkirch argue that the existing governance structure of the Bank is out of step with international practices that have spread quickly over the past decade.

What Now? Addressing the Burden of Canada's Slow-Growth Recovery

The Canadian economy faces serious short-term macroeconomic challenges, the most important of which is addressing the burden of our slow-growth recovery. The sources and consequences of this slow growth are the focus of this Commentary. Canadian monetary policy has little ability to further stimulate Canadian growth. Given the large amount of uncertainty now faced by Canadian firms, further reductions in the policy interest rate are unlikely to be effective in stimulating aggregate demand. In addition, the ongoing problems associated with very low interest rates cannot be ignored and may soon present the Bank of Canada with a compelling case for rate increases. Canadian fiscal authorities have more room to manoeuvre than their counterparts in many other developed countries. Yet there remain solid arguments for budgets to be brought back to balance in the next few years. One is that discretionary fiscal policy is an ineffective pro-growth policy when the economy is not experiencing a sudden collapse of aggregate demand. Another is the longer-term budgetary challenges that Canadian governments will face over the next few decades as a result of population aging. Neither fiscal nor monetary policy is therefore likely to stimulate Canada’s economic growth over the next few years. This lack of stimulus from traditional macroeconomic policy suggests that any pick-up in Canadian growth will rely on a recovery of private demand. Given the lingering uncertainty and the continued slow pace of the global economic recovery, however, a significant rebound in Canadian private demand is unlikely in the near future. High household debt suggests that consumption is an improbable source of near-term growth. An investment revival will require a return of corporate confidence, while a rally in Canadian exports will depend on a strong and sustained foreign recovery. A central conclusion of this Commentary is therefore that Canadian policymakers should accept the continuation of Canada’s slow-growth recovery for the next few years. Slow growth has undesirable consequences, however, including longer unemployment spells, more part-time employment, and a greater incidence of long-term unemployment. Policymakers should focus on addressing the associated burden by enhancing income support for the unemployed, increasing the mobility of workers and improving incentives for labour-market training.

Monetary policy reactions and the exchange rate: a regime-switching structural VAR for Canada

The objective of this study is to identify monetary policy reactions in a nonlinear, structural vector autoregression (VAR) framework, with regime-switching contemporaneous policy responses in a small open economy. The key finding is that monetary policy in Canada responds contemporaneously to disturbances in the real exchange rate, as well as the output gap and inflation. The Bank of Canada is found to have much larger responses to exchange rate fluctuations during volatile periods than more stable periods. However, the Bank is found statistically to have a relatively linear reaction function with symmetric responses to output and inflation shocks across interest rate regimes. The estimates for the contemporaneous responses to the output gap in both regimes are found to be virtually identical to the 0.5 weights in the original Taylor rule for the United States, while the responses to inflation surprises are slightly smaller. Overall, the Bank of Canada is found to have operated within the range of optimal responses suggested by small-scale structural models in the normative literature on monetary policy rules.

Nonlinearities in exchange rate determination in a small open economy: Some evidence for Canada

We analyze bilateral Canadian-US dollar exchange rate movements within a Markov switching framework with two states, one in which the exchange rate is determined by the monetary model, and the other in which its behavior follows the predictions of a Taylor rule exchange rate model. There are a number of regime switches throughout the estimation period 1991:2–2008:12 which we can each relate to particular changes in Canadian monetary policy. These results imply that an active monetary policy stance may account for nonlinearities in the exchange rate-fundamentals nexus. The strong evidence of nonlinearities also confirms the notion that exchange rate movements cannot be explained exclusively in terms of any one particular exchange rate model.