Mark Carney explains central bank speak

The governor on 'stock phrases or code words'

Mark Carney just spoke at the CFA Society in Toronto. The theme is “guidance,” or how central banks can try to influence investors’ expectations by indicating the likely future movements of interest rates. As the Globe’s Kevin Carmichael noted last week, Carney’s tenure at the Bank has brought about some important changes on guidance. The governor “embraced the academic argument that a little uncertainty could be good for financial stability: a healthy debate about the likely path of interest rates eliminates the risk of a one-way bet, which essentially was the case in the U.S. ahead of the financial crisis.”

Here are some interesting bits from the prepared remarks, which the governor said do not contain any new guidance about the Canadian economy:

It’s a good idea to explain not just what the Bank is likely to do, but also why—especially when managing inflation isn’t the Bank’s only concern:

The global crisis was a stark reminder that economic stability and financial stability are inextricably linked, and that pursuing the first without due regard for the second risks achieving neither. While the primary tools to deal with financial stability are micro- and macroprudential regulation and supervision, it may be appropriate in some circumstances for monetary policy to contribute to financial stability directly by complementing macroprudential policy.

More specifically, because the consequences of financial excesses may be felt over a longer horizon than other economic disturbances, the potential may exist for tension between price and financial stability considerations over the typical monetary policy horizon. In current circumstances, the Bank may want to set interest rates higher than would otherwise be warranted to bring inflation back to target within the typical six- to eight-quarter time frame.

But that flexibility does not exist in a vacuum, and should never be used by stealth.

The most recent Financial System Review elaborates on risks related to household imbalances in Canada. Their evolution may be a factor affecting the timing and degree of any withdrawal of monetary stimulus. If the Bank were to lean against such imbalances, we would clearly say we are doing so, and indicate how much longer we expect it would take for inflation to return to the 2 per cent target.

Our current guidance is that “some modest withdrawal of monetary policy stimulus will likely be required, consistent with achieving the 2 per cent inflation target. The timing and degree of any such withdrawal will be weighed carefully against global and domestic developments, including the evolution of imbalances in the household sector.”

Our current guidance indicates that some policy action may be necessary, encouraging a degree of prudence in household borrowing. The share of new fixed rate mortgages has almost doubled to 90 per cent this year, reflecting the combination of attractively priced fixed-rate mortgages and the tightening bias of the Bank of Canada.

Telling investors how interest rates are likely to move can be very useful in times of crisis and when interest rates as already as low as they can go: 

While the Bank believes it appropriate to be sparing in forward policy guidance under ordinary circumstances, the calculus changes under extraordinary ones. When conventional monetary policy has been exhausted at the zero lower bound (ZLB) on nominal interest rates, the additional stimulus that is likely to be called for is impossible to achieve using the conventional interest rate tool. Extraordinary forward guidance is one unconventional policy tool, along with quantitative easing and credit easing.

The Bank of Canada used extraordinary forward guidance in April 2009, when the policy interest rate was at its lowest possible level and additional stimulus was needed. At the time, we committed to holding the policy rate at that level through the second quarter of 2010, conditional on the outlook for inflation. In effect, we substituted duration and greater certainty regarding the interest rate outlook for the negative interest rate setting that would have been warranted but could not be achieved. The Bank’s conditional commitment succeeded in changing market expectations of the future path of interest rates, providing the desired stimulus and thereby underpinning a rebound in growth and inflation in Canada. When the inflation outlook – the explicit condition – changed, the path of interest rates changed accordingly.

Our conditional commitment worked because it was exceptional, explicit and anchored in a highly credible inflation-targeting framework. It also worked because we “put our money where our mouths were” by extending the almost $30 billion exceptional liquidity programs we had in place for the duration of the conditional commitment. And it worked because it reached beyond central bank watchers to make a clear, simple statement directly to Canadians.

Obviously the optimal policy path will differ for central banks, depending on their circumstances and mandates. For example, the Federal Reserve indicated at its September meeting that its policy rate could be expected to remain at exceptionally low levels until mid-2015, and provided additional certainty with respect to its reaction function by linking future unconventional monetary policy to substantial improvements in the outlook for the U.S. labour market. Further, it indicated that it will leave highly accommodative policy in place “for a considerable time after the economic recovery strengthens.” The Fed also expanded its large-scale asset purchases, dubbed “QE3,” consistent with this enhanced forward guidance.

In extreme circumstances, when central banks must keep interest rates at rock-bottom for a prolonged period of time, it might be a good idea to tie future rate hikes to targets in non-inflation adjusted GDP (which captures both inflation and economic growth):

If yet further stimulus were required, the policy framework itself would likely have to be changed. For example, adopting a nominal GDP (NGDP)-level target could in many respects be more powerful than employing thresholds under flexible inflation targeting. This is because doing so would add “history dependence” to monetary policy. Under NGDP targeting, bygones are not bygones and the central bank is compelled to make up for past misses on the path of nominal GDP.

Bank of Canada research shows that, under normal circumstances, the gains from better exploiting the expectations channel through a history-dependent framework are likely to be modest, and may be further diluted if key conditions are not met. Most notably, people must generally understand what the central bank is doing – an admittedly high bar.20

However, when policy rates are stuck at the zero lower bound, there could be a more favourable case for NGDP targeting. The exceptional nature of the situation, and the magnitude of the gaps involved, could make such a policy more credible and easier to understand.

Of course, the benefits of such a regime change would have to be weighed carefully against the effectiveness of other unconventional monetary policy measures under the proven, flexible inflation-targeting framework.”


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