Part 1 provided a brief overview into the operations of the Bank of Canada.
This article analyses the “transmission mechanism” used by the Bank of Canada. The information presented below comes from the Gordon Thiessen’s paper that is covered in Part 1 of this series.
When central banks implement monetary policy – through adjusting the supply of settlement balances to financial institutions – they set in motion a series of consequences that start with an influence on financial markets, works through changes in spending, production and employment, and ends with an effect on the price level or, more specifically, the rate of inflation in the price level
Economists call this chain of developments – the Transmission mechanism. And the individual links through which monetary policy impulses proceed are known as transmission channels. The main channels of monetary policy transmission are set out in a simplified, schematic form in the chart.
As you can see, this mechanism works in a top-down fashion, with the central bank working in a centralized fashion.
Stages of the Transmission Mechanism
This occurs when the central bank adjusts the size of its balance sheet to alter the supply of base money in the financial system.
Traditionally, commercial banks such as RBC, Scotia Baank, and TD held a certain amount of base money because of legally imposed reserve requirements.
However, since the elimination of reserve requirements in Canada – thanks to Brian Mulroney – a demand for base money by the major banks and certain other important financial institutions exists because they settle the net outcome of the daily clearings of payments directly on the books of the Bank of Canada
Because of this, such institutions are called direct clearers. And “settlement balances” is now the appropriate term to describe the deposits of the direct clearers at the Bank of Canada.
Central banks can adjust the supply of settlement balances available to direct clearers in a number of ways:
Textbooks focus on open market operations. Canada’s central bank relies mainly on a technique involving daily transfers of government deposits between the direct clearers and the Bank of Canada. Central to the process, is that the Bank of Canada, is able to provoke a reaction from the direct clearers by confronting them with an excess or shortfall of settlement balances
In this way, the Bank of Canada uses their control over settlement balances, to influence the interest rate most relevant to transactions by financial institutions aimed at adjusting these balances. This is the rate on one-day loans, sometimes called the over-night rate of interest
Movements in the over-night rate in turn influence other interest rates and the exchange rate. On a typical day, after the previous day’s payment items have cleared, some direct clearers will end up with a surplus of settlement balances and others with a shortfall.
The central bank can only alter the overnight interest rate, if it acts to create an overall shortfall or surplus for the group as a whole, relative to their desired balances at the Bank.
Faced with a shortfall, the direct clearers will call one-day loans to security dealers, sell very short-term liquid assets from their portfolio, or bid more aggressively for very short-term wholesale deposits. All three actions tend to put upward pressure on the one-day rate of interest and other very short-term rates.
Conversely, when the direct clearers as a group have a surplus of settlement balances, they will tend on balance to extend more one-day loans to dealers, buy very short-term liquid assets, and be less aggressive in bidding for very short-term deposits, thereby putting downward pressure on the one-day rate and other very short-term rates
Even at this initial stage of the transmission process, the Bank is faced with an element of uncertainty, since the desired settlement balances of direct clearers cannot be forecast with precision. Hence, there can be a lag of a day or two, before the Bank’s actions have the desired effect on very short-term rates.
Stage 2: From very short-term interest rates to the rest of the term structure and to the exchange rate
By altering the one-day rate (Stage 1), the central bank will influence the rest of the term structure of interest rates as well as the interest rate, but that influence is not a precise one since it depends on the expectations and reactions, of the financial markets.
The level of the money market rates beyond the very short term is closely related to the market’s expectations of the future path of one-day rates.
If the bank has just taken action to push up the one-day rate, say because of the release of new information about the strength of demand pressures in the Canadian economy, the impact of this increase on interest rates for one month, 3 months, and so on, will depend on how long market participants expect the bank to maintain the higher one-day rate.
Thus in this way, the less uncertainty there is in the markets about the Bank’s intentions, the smoother the response will be of other short-term rates.
In interpreting the movements of interest rates further out on the maturity spectrum, it is best to think of medium- and longer-term rates in Canada as depending on expectations of the future path of real interest rates (including risk premiums) and that of the rate of inflation.
And expectations of real interest rates over the long term (apart from risk premiums) are likely to be related mainly to international factors.
These international factors include expected world-wide movements in aggregate demand over the next few years and the expected profile over the longer run of the supply of saving (net of government dis-saving) and of the demand for investment around the world.
Risk premiums in interest rates will reflect such factors as the expected path of fiscal policy and political developments in Canada.
Expected inflation, depends mainly on the market’s expectation’s about monetary policy in Canada. Given the uncertainty around all of these expectations, it is not surprising that markets react strongly at times, to the release of information which changes their views about any of these factors.
The trend of financial liberalization throughout the last few decades has made the financial markets more inter connected and the size of international financial flows has increased significantly. Thus, because of this, a major shift in expectations in one market can have a substantial effect on interest rates elsewhere in the world.
The effect of a change in very short-term interest rates on the exchange rate for the Canadian dollar is also a function of market expectations.
The longer a new level of very short-term rates encouraged by the Bank’s actions is expected to prevail, the greater the effect on the exchange rate. So the clearer the basis for the Bank’s actions, the more predictable the effect on the exchange rate will be.
The exchange rate is also affected by factors other than Bank of Canada policy actions.
For example, the Canadian-US dollar exchange rate is also influenced by U.S. monetary policy, by the stance of fiscal policy in both countries, by the relative positions of the economic cycle in Canada and the US, by the standing of the U.S. dollar relative to overseas currencies, as well as by political events
So, what would happen if the Bank acted in a way that the market viewed as inappropriate to the circumstances?
Lets say, that the Bank acted to ease the one-day rate of interest in response to new information, suggesting there was less inflation pressure in the economy than had been anticipated.
If the markets (investors) felt that the Bank’s actions involved taking excessive risks on the side of higher inflation, than investors would immediately become more reluctant to hold Canadian dollar instruments at current interest rates, because of their expectation of higher inflation in the future.
Also, investors uncertainty about the future would increase because, at higher rates, inflation tends to be less predictable.
Because of this, there would be upward pressure on interest rates beyond the shortest term, both because of the higher expected rate of inflation, and because of the higher risk premiums that investors would require, in order to compensate for the increased uncertainty.
In addition, with the increased reluctance of investors to hold Canadian dollar instruments, the exchange rate would come under downward pressure. If the market began to extrapolate the downward movement of the currency, it would intensify the upward pressure on interest rates as investors moved out of Canadian dollar investments to avoid a potential capital loss.
To summarize all of the above succinctly, while actions by the Bank to bring about a decline in one-day rates in the face of a market that thought that such a change was inappropriate might still force a decline in interest rates at the very short-term end of the money market, perhaps even out to 30 days – they would ultimately result in a rise in rates further along the yield curve because of increased fears of inflation and a declining currency.
To also note, investors in long-term bonds, have become more sensitive over the last 20 years to any kind of inflation, or to any suggestion that a central bank has become more willing to take risks with inflation and therefore with a depreciating currency. This is definitely due to the high rates of inflation that prevailed in the 1970’s and early ’80s.
In a similar fashion, long-term bond markets now respond to fiscal concerns quickly and directly, presumably because of their concern that countries may act to monetize the debt when it becomes too burdensome. Monetizing debt is a two-step process where the government issues debt to finance its spending and the central bank purchases the debt, leaving the system with an increased supply of base money.
Thiessen also noted that there were times when the markets became nervous and volatile because of economic shocks or concerns about policies. He stated that central bank actions have to be directed to coping with disorderliness in the markets.
This is because there have been occasions in the past when downward momentum in the Canadian dollar undermined confidence and encouraged extrapolative expectations of further declines in the Canadian dollar, which then fed back on interest rates, pushing them sharply higher.
In this kind of circumstance, the Bank’s immediate task was to calm markets by helping them to find new trading ranges with which they were comfortable. Once the markets had settled down, the bank would have been able to focus attention on the underlying economic situation, which typically had become lost to view during the turmoil
Stage 3 – From interest rates + the exchange rate to Aggregate demand
This stage in the process involves the transmission from interest rates + exchange rate to aggregate demand.
Changes in interest rates affect aggregate demand through a number of channels:
- Cost of capital
- Incentive to save rather than spend
- Effects on wealth and cash flow
The main components of aggregate demand that are affected include:
- Consumer spending on durables. Consumer durables are items that provide a flow of services to a consumer over a period of time. Examples include new cars, household appliances, audio-visual equipment, furniture etc.
- Business investment in fixed capital and inventory management
The extent of the response of spending, will depend in part, on how long the changed level of interest rates is expected to persist. this will be an important factor for those entities that borrow at the shorter end of the market.
Ways the exchange rate affects demand:
A change in the value of the Canadian dollar will initially change the prices of those goods and services produced in Canada that are traded internationally and whose prices are set in world markets, vis-a-vis those whose prices are not, or at least not entirely, determined in world markets.
These changes in relative prices will set in train a series of demand and supply responses and that will affect the output of Canadian-produced goods largely through their impact on exports and imports
These responses do not take place overnight. Their size is dependent on whether the markets expect the change in the exchange rate to be transitory or long-lasting.
The following is presented as a sample scenario, where a sharp downward shock to aggregate demand in Canada has lead to a decline in interest rates and to a significant depreciation of the Canadian dollar.
In this scenario, the Canadian dollar price of those Canadian products whose prices are determined in world markets, such as most raw materials, will rise, making their production more profitable and induce producers to exploit existing sources of production more intensively.
Over time, suppliers will be induced to increase their capacity to produce such goods.
How strong the investment response will be, and how soon it will begin, will depend importantly on expectations about the duration of the lower value of the Canadian dollar.
If the decline were expected to be transitory or if there were a great deal of uncertainty about its persistence, producers would hesitate to expand their productive capacity.
The conclusion from this third stage of the transmission mechanism, is that there will typically be a significant response of spending to interest rate + exchange rate movements, but that neither the extent, nor the timing can be pinned down to precision.
Expectations of future developments and the uncertainty surrounding the likely outcomes, can have an important effect on how much and how quickly various entities change their expenditure patterns in response to changes in interest rates and in the Canadian dollar.
Fourth Stage: From aggregate demand to inflation
In the Bank’s view, underlying inflation is affected by the level of slack in the economy and by the expected rate of inflation.
The driving force behind inflation over time is thus, the cumulative effect of the pressure of aggregate demand on capacity. In the years of high inflation, there was a close link between the prevailing rate of inflation and expected inflation.
Thus, a period of excess aggregate demand, resulted in an increase in the rate of inflation, which in turn, fed quickly into expected inflation, placing even greater upward pressure on inflation in a process that eased only when the excess demand was eliminated.
Both aggregate demand, and prices are subject to economic shocks, and demand shocks can be external or domestic in origin.
Demand shocks originating domestically include fiscal actions, as well as sudden shifts in desired investment by companies or purchases of consumer of consumer durables by households.
There are also supply shocks, which typically affect prices directly. These are events such as those leading to the increases in oil prices in the 1970’s, natural disasters that affect the supply and prices of agricultural products, and changes in technology and shifts in world trade which can affect the availability of goods and services
Supply shocks can shift potential output in the economy. Potential output is in any case, very difficult to demonstrate empirically, thus one must be cognizant of the uncertainties surrounding any measure of slack.