How many bullets does the Bank of Canada have left in its chamber?

It's been a while since I blogged about Canadian monetary policy, but Luke Kawa's recent tweet on the topic of Canada's effective lower bound got me thinking.

BoC has referred to 0.25% as its "effective lower bound" -- Shenfeld suggested that any lower, BoC thinks there'll be problems in money mkts

— Luke Kawa (@LJKawa) August 4, 2015

Luke is referring here to CIBC chief economist Avery Shenfeld's recent missive on how the Bank of Canada might react if the Canadian economy's losing streak were to continue. According to Shenfeld, the Bank of Canada has one final quarter point cut left in its quiver—from 0.5% to 0.25%. Should the bleeding continue, Governor Stephen Poloz can then turn to forward guidance and only when that has been exhausted will quantitative easing become a possibility.

Really? The Bank of Canada can't go below 0.25%? Has Shenfeld not been following what has been occurring outside Canada's borders over the last twelve months? Sweden's central bank, the Riksbank, has cut its repo rate to -0.35% while the European Central Bank has ratcheted its deposit rate down to -0.2%. The Swiss National Bank is targeting an overnight interest rate of -0.75%, down from 0% the prior year, at the same time that the Danmarks Nationalbank currently maintains a certificate of deposit rate of -0.75%. I've been covering this stuff pretty exhaustively here, here, here, here, and here.

After digging a bit further, I was surprised to find that the sort of interest rate emasculation implied in Shenfeld's piece is endemic here in Canada. David Rosenberg of Gluskin Sheff, for instance, recently said that Poloz has "just one bullet left in the chamber" while the FP's John Schmuel wonders what will happen if the Bank of Canada is forced to use its "last remaining lifeline and cut its rate to zero." The Bank of Canada is also a transgressor in spreading the meme: on its FAQ, the Bank says that the overnight rate's lowest possible level—its effective lower bound—is 0.25%.

One reason the faux 0.25% lower bound continues to circulate in the public discourse is the somewhat lazy reliance commentators have on the Bank of Canada's credit crisis playbook as a model for how low rates can go. In addition to implementing forward guidance during the crisis, the Bank reduced the overnight rate to 0.25% by flooding the system with excess balances. But this playbook has gone stale. As I've already pointed out, a number of European central banks have demonstrated the possibility of going below zero. A Bank of Canada deposit rate cut to as deep as, say, -0.50%, combined with an overnight target of -0.25, effectively buys Poloz three more 25 basis point interest rate cuts, not just one.

Ask folks why Canadian markets can't bear negative interest rates and there's typically a lot of arm-waving and mumbling about money markets. Case in point is Shenfeld on the +0.25% level: "In the Canadian money market structure that’s as low as she gets, and effectively represents the zero lower bound for monetary policy." I'm not aware of a single Canadian fixed income product that can't bear slightly negative interest rates. Would maple syrup commercial paper markets come to a standstill if the Bank of Canada cut rates to -0.25%? Would the market for Gordie Howe bonds collapse? While no doubt a nuisance, the transition to negative rates has been managed by money markets in Denmark, Sweden, Switzerland, and the rest of Europe without major mishap. There's simply no justification for Canadian exceptionalism.

While slightly negative rates won't cause structural problems in money markets, deeply negative rates would certainly be problematic. Send rates low enough and bank runs will begin as people cash in their negative-yielding money market instruments for paper dollars. At some point the banking system would cease to exist. But this doesn't occur at Shenfeld's so-called 0.25% lower bound, nor at -0.75%. Thanks to the carrying costs of bulky banknotes, it probably only starts to be a problem somewhere between -1.0% to -3.0%. The existence of a wide safe zone before hitting those levels gives the Bank of Canada a lot more lifelines than just one.

The last reason for the circulation of a false lower bound in Canadian monetary policy discussion is vested interests. I doubt that Canada's big banks are fond of incurring the frictional costs associated with transitioning to a negative rate world. Better to "wipe out" that possibility from the Overton Window and push something less-threatening like forward guidance.

Let me be clear that I have no specific insight into whether the Bank of Canada should be loosening or not. What is important is that the Bank has flexibility to the downside should it decide that easing be necessary. Breathing space is important because pound-for-pound, actual interest rate cuts are always better than unconventional policies like forward guidance—the promise to keep interest rates too low in the future—or quantitative easing. A move to -0.15% or -0.25%, should it be necessary, represents a continuation of the Bank of Canada's decades' long method of implementing conventional monetary policy via direct interest rate adjustments. It's not fancy, but it has been in place for a long time and everyone pretty much gets it by now. Central bank guidance, on the other hand, is complicated and suffers from the fact that the public can never be sure that a three-year promise initiated by a Conservative-appointed governor will stay in place should an NDP-appointed governor take his place. As for quantitative easing, it doesn't even work in theory, as pointed out by none other than Ben Bernanke. (Or see how New Zealand's cashing up the system had no influence on prices)

Incidentally, if Canada were to suffer a broader shock than the current one and the Bank of Canada found it necessary to go deep into negative territory, say -6%, there are all sorts of ways it can go about doing so without causing stress in money markets. In fact, economist & blogger Miles Kimball recently visited the Bank of Canada to explain how to go about implementing extremely low rates without igniting a run into paper dollars, or what he refers to as massive paper storage. I've written about some "lite" ways to go about doing so as well.

Interestingly, Kimball writes that the Bank of Canada already has an “Effective Lower Bound” working group that is focused on "exploring the possibilities for negative interest rate policy in the next recession." So while the public discourse on Canadian monetary policy seems to have settled on the "one remaining lifeline" view, it appears that internally that is not the case—the Bank of Canada knows that it has much more up its sleeve.

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Various charts:

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