Tuesday, June 1, 2010

The Bank of Canada Tightens

The Bank of Canada announced a reconfiguration in its monetary policy stance. In case you do not know the institutional setup, the Bank of Canada lends at the "Bank Rate," roughly equivalent to the discount rate, and accepts deposits at the "deposit rate," the equivalent of the interest rate on reserves (IROR) in the US. The policy target rate is the overnight rate. For some time now, the Bank of Canada has set the target overnight rate at 0.25%, and the deposit rate was also 0.25%. The Bank Rate was 0.5%. Consistent with that, the Bank had aimed to have a positive quantity of reserves in the system overnight (a significant quantity, but modest by current Fed standards). The change in policy is the following. The deposit rate stays at 0.25%, the target overnight rate increases to 0.5%, and the Bank Rate is now set at 0.75%. The relationship among the three rates is identical to what it was pre-financial crisis, i.e. the Bank Rate is the target rate plus 25 basis points; the deposit rate is the target rate minus 25 basis points.

Given that the Fed is now in a regime where it pays interest on reserves, it is useful to pay attention to how the Bank of Canada conducts policy - they have been doing this for a long time now (and with no reserve requirements as well). What the Bank understands is that, if they want a positive quantity of reserves in the system overnight, the target rate has to be equal to the deposit rate. In the US, the fed funds rate can be lower than the IROR because Fannie Mae and Freddie Mac do not earn interest on their reserve accounts with the Fed, and there is some friction (which nobody seems to understand completely, as far as I know) which inhibits arbitrage. As I have said in the past, the relevant policy rate in the US currently is the IROR, given the positive quantity of excess reserves in the system.

The Bank of Canada has an inflation target of 2% per annum, which they appear to be concerned about. If you read their description of the state of the Canadian economy here, they are New Keynesian Taylor Rule policymakers - they care about output gaps. Note that the recession in Canada looks broadly similar to the US one, in terms of the path followed by GDP - their last couple of GDP numbers came in quite strong. However, the labor market picture is different - for example the unemployment rate is considerably lower than in the US (by the way, I couldn't find conveniently accessible Canadian data, other than downloading from the StatCan site - can anyone help me?), and on average it is usually higher (due to differences in unemployment insurance for example). Canada also has a somewhat booming housing market - very different from here of course. Their resource sector (commodity price fluctuations aside) seems to be looking quite good as well.


  1. Stephen:

    One very important difference between Canada and the US's recession is that Housing led the recession in the US, while housing followed the recession in Canada.

    Hence, the recent recovery in Canada is largely attributed to a recovery in housing (According to David Rosenberg -- 70% of GDP growth in Q4/Q1 was housing related). Excellent discussion on the rate setting mechanism. Never seen it so well explained.

  2. Also, within the next two weeks, BoC aims to reduce the settlement balance to 25mil$, basically going back to zero reserve. This is quite different from what the Fed is facing now.

  3. Yes, my understanding of the $25 million settlement balance, is that this is just to account for the occasional error, i.e. an LVTS participant receives a large payment at the end of the trading day, and can't find a place to park it overnight, other than in its reserve account with the Bank.

  4. Professor,

    Have you tried the World Bank Development Indicators, or the OECD Database for Canadian Data? That's what I usually use, but standardized cross-country data usually comes at the expense of quarterly data. Hope this helps.

  5. Thanks, Hamed. I was hoping there was something out there like the St. Louis Fed database for the US, where you can eyeball the standard time series.

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