Surprise interest-rate cuts by central banks have become so commonplace over the last few weeks that they no longer shock.
The Bank of Canada slashed its benchmark interest rate by a half point on March 27, dropping the benchmark to 0.25 per cent, the lowest the central bank thinks it can go without disrupting the proper functioning of financial markets.
At the start of the month, the policy rate was 1.75 per cent. Never has Canada’s central bank reduced borrowing costs so quickly, an acknowledgement of the severity of the coronavirus crisis.
Nor has the Bank of Canada ever sought to compress interest rates by using its ability to create money to buy financial assets, a strategy known as quantitative easing, or QE. That precedent too is about to change.
A firefighter has never been criticized for using too much water
Along with the interest-rate cut, the central bank said it will begin buying at least $5 billion worth of government bonds per week until the economy turns around. The idea is to flood fear out of credit markets by pumping them full of cash. Other central banks have used QE to great effect, but Canada never has felt the need to go there.
But this time is different. The Bank of Canada’s trading desk has been watching markets for government bonds, mortgage-backed securities, and short-term business loans become increasingly rigid as lenders attach severe risk premiums to the interest rates they charge in normal times. With so many companies and households facing bankruptcy, lenders can’t be certain they will get their money back.
The knowledge that the central bank will be in the market every week buying large amounts of these securities should cause those risk premiums to shrink. The Bank of Canada also set up a separate program to buy commercial paper. The pivot to QE suggests Canada is facing a rougher storm than occurred during the Great Recession, when the Bank of Canada dropped the benchmark interest rate to 0.25 per cent, but stopped there.
“We’re doing a tremendous amount,” Stephen Poloz, the governor, told reporters on a conference call. “A firefighter has never been criticized for using too much water.”
Forecasters have been releasing progressively dire outlooks on a daily basis.
Earlier this week, the International Monetary Fund said the world is facing an economic contraction “at least” as severe as the one that followed the financial crisis in 2008. In Canada, the Office of the Parliamentary Budget Officer said on March 27 that gross domestic product could collapse by 25 per cent in the second quarter, and contract about five per cent in 2020 from the previous year, which would be the biggest decline since 1962.
Poloz avoided arithmetical predictions about the future. He said the Bank of Canada will release its quarterly economic report on April 15. That release normally would have come with a policy update, but it should be clear to everyone by now that policy makers feel unconstrained by the calendar. Poloz said he was focused on laying the foundation for a quick return to normalcy.
Still, Poloz indicated that the benchmark rate is now as low as it’s going to go unless conditions change from terrible to catastrophic. He acknowledged that negative rates are a “theoretical” possibility, but reiterated that he thinks any gains would be outweighed by the difficulties that would cause banks and others in the financial system.
“We’ve seen a number of experiences with negative interest rates and our conclusion from that is that the negative effects on the financial system are pretty significant and at this stage our main focus is on the functioning of the financial system,” Poloz said. “At this stage, it would be non-sensible to think of interest rates going lower than this. We consider this to be the effective lower bound.”
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