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Reducing Market Uncertainty – Inner Machinations of the Bank of Canada

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5 Initiatives taken by the Bank to Reduce Market Uncertainty

 

The Bank of Canada outlined 5 initiatives that were taken in order to reduce the market uncertainty that may exist about the Bank’s behaviour. These are indicated below.

 

Initiative 1)      Establishing price stability as the goal of monetary policy

 

In Gordon Thiessen’s paper (Introduced in Part 1) he stated, that one of the benefits of price stability is that the increased certainty brings with it the certainty in the economy.

Some in the financial community object to this focus on the control of inflation as the final objective of monetary policy, because they worry it might encourage central banks to ignore the level of economic activity and employment.

This is especially crucial and Thiessen even states,

There is no question that monetary policy has a short-term influence on demand, production and employment, but surely the notion of a long-run inverse trade-off between inflation and unemployment has been widely discredited

 

According to him, in the long run, the impact of monetary policy is on inflation, and the central bank must set its objective in terms of the variable it can expect to influence

 

Gordon also added, “I hasten to add that the goal of price stability is not at odds with the achievement of economic growth and expanding employment.

According to him, this is because price stability is helpful in making investment decisions that will improve productivity, and be good for growth.

Following a steady path aimed at maintaining price stability means that  monetary policy will operate as a sort of automatic stabilizer for the economy. As such, excessive demand pressures that could lead to inflation would be dampened by such a monetary policy, while weak demand that could result in price deflation would lead to a more stimulative monetary condition.

In contrast to this, a monetary policy that accommodates inflation will lead to cycles of boom and inflationary excesses, followed by recessions made more difficult by the need to correct inflation-related distortions.

Thus, he argues that price stability will contribute to overall economic stability.

However, many market critics contend that in a free market setting, booms and busts are to be expected and part of the natural cycle of capitalism. Critiques of the Central Bank’s objectives are addressed in later parts of this series.

 

Initiative 2) Inflation-control targets

 

When a country is suffering from inflation, the announcement or reiteration by the central bank of the goal of price stability will not suddenly persuade the public to shift their expectations and begin planning on the basis of price stability

The questions then arise: What does price stability mean in terms of the actual change in the price index? Over what time period will it be achieved?

In Canada, over the 1970s and early 1980s, the high inflation indicated that the general commitment by the Bank to move gradually to price stability still left too much public uncertainty about the objective of monetary policy.

Thus, after 2 decades of inflation, the credibility of such a general commitment by the Bank of Canada to price stability was not sufficient by itself to contribute in bringing about the changes in behaviour and expectations which would facilitate a decline in inflation

To alleviate market uncertainty,– the Bank of Canada and the Government of Canada introduced a series of reforms in 1991, with a set of explicit targets to help make the path to price stability  more concrete.

Some have argued this was because of  equalizing Canada under Free Trade Agreement, rather than ‘price stability”.

In either event, the inflation-reduction targets were aimed at bringing the rate of inflation down to 2% (or a range of 1 – 3%) by the end of 1995, to be followed by a further downward movement towards price stability

 

In Dec 1993, a further set of inflation-control targets were jointly announced by the Bank and the government, which extended the range of 1-3% inflation through 1998.

This would then be followed by a movement to price stability, to be defined operationally by 1998.

By making its inflation-control objectives more explicit due to the reforms, the Bank hoped not only to influence inflation expectations, but also to reduce market uncertainty in the economy and in financial markets.

With credible targets, inflation expectations (and thus inflation), are less likely to react to the temporary demand and supply shocks described earlier.

The argument relayed here, is that the targets act as a form of discipline on the Bank, by making it more “accountable” for its actions, and that, in turn makes the monetary policy actions more predictable and less a source of uncertainty for others as they make economic decisions.

 

 

Initiative 3) The use of intermediate targets and indicators

The uncertainties and long lags, in the “transmission process” leave everyone, including central banks, in an unsure and unsettled position, while awaiting the effects of monetary policy actions on inflation.

Because of this, central banks have made use of various intermediate indicators, and have (at times) set targets in terms of those indicators, in order to assist in the conduct of policy and to provide more information, and more comfort to observers that monetary policy was on track.

With the rise in inflation and its persistence in most countries in the 1970s’, the central banks shifted their focus from operational targets for short-term interest rates, to intermediate targets for quantitative variables expressed in nominal terms.

As such, many central banks established these intermediate targets in terms of monetary aggregates. Monetary aggregates are broad measurement categories employed by Central banks in order to determine the total value of the money supply within an economy.

These aggregates were expected to provide an anchor for monetary policy, and to avoid the type of policy which inadvertently accommodated the accelerating inflation of the late 1960s and early 1970s.

The Bank of Canada adopted the M1 monetary aggregate during the period between 1975-1982. As the Bank soon learned, although this target proved useful initially, it did not help the Bank to hold down the rate of inflation when demand pressures built up in the late 1970’s.

Part of the problem was that the M1 monetary aggregate was more responsive to the Bank’s actions on very short-term interest rates, than were aggregate demand and inflation.

Also important to note, is that extensive financial innovation that occurred made interpretation of the aggregate more difficult as well, and it was finally dropped as a target in 1982.

Thiessen noted, that the Bank had examined other aggregates to use as possible intermediate targets in the period since 1982, however none of them turned out to be sufficiently reliable.

Thus, for many years, the Bank had to rely on operational targets for short-term interest rates.

 

Monetary Conditions Index

 

Another big evolution for the Bank, was their use of monetary conditions, rather than short-term interest rates, as the operational guide to policy. Monetary conditions are the combination of short term interest rate + exchange rate movements.

The Bank adopted monetary conditions as an operational guide, because they recognized, that under a flexible exchange rate regime, monetary policy operates through both interest rates and the exchange rate.

Hence when the central bank is acting to ease, or tighten its policy stance (in response to new information), it must take into account, developments in both channels through which its actions influence aggregate demand.

The Bank even constructed an index of monetary conditions (MCI) by weighting short-term interest rates and the effective exchange rate, by the relative size of their estimated effects on aggregate demand.

So a movement in the MCI index, is a short-hand measure of the effect on aggregate demand of the changes in both channels through which monetary actions have their principal effect

Also important to note, is that the Bank has no direct control  over its actions between interest rates and the exchange rate.

Because of uncertainties in financial markets, an easing in the stance of monetary policy will result in a small decline in interest rates and a sizable depreciation of the Canadian dollar.

And at other times, the same action may lead to a larger decline in interest rates, and little depreciation of the dollar.

In this context, the Bank does not control the level of the exchange rate. Rather, it is the market’s interpretation of what the central bank is trying to do in the context of the economic environment, that determines what happens to the exchange rate in response to central bank actions

When monetary conditions are used as an operational guide, it is not possible to set a target path for the MCI which remains unchanged over time.

Rather, monetary conditions must be constantly re-evaluated and adjusted to respond to shocks of one sort or another to ensure that the economy remains on track to the inflation-control objective

 

Initiative 4) Target ranges for the overnight rate

 

To provide more ‘Transparency’, the Bank decided in the middle of 1995, to change its operating tactics in order to be more explicit about the range into which it wanted the one-day rate of interest to fall.

Since that time, there has been a target range of 50 basis points for the one-day rate.

The Bank has also intervened actively through its operations in the money market, to hold the one-day rate within the range and to make the limits of the range clear to the market.

When the Bank decides to change the target range, the market learns of the change very quickly from the rates at which the Bank intervenes in the overnight market.

Thus, by making the target range for the overnight rate explicit, the Bank hopes to reduce the market uncertainty about its intentions that sometimes has interfered with the transmission of monetary policy actions to interest rates further out along the yield curve and to the exchange rate

 

 

Initiative 5) More information on the Bank’s operations

The Bank also began to provide more public information on their monetary policy operations and their interpretation of economic and financial developments

 

In Thiessen’s concluding remarks, he said,

The Bank has a direct effect on very short term rates and through them, [the bank] has an influence on the exchange rate. Our main effect on longer-term rates occurs indirectly through our influence on market expectations regarding inflation. These influences are sufficient for the Bank to carry out an independent monetary policy to control inflation.

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