The Bank of Canada normally responds to the threat of a large recession by aggressively cutting interest rates. It won’t be able to use this strategy the next time around: short-term interest rates would hit zero before the job is done. Instead, the Bank will have to rely on large-scale purchases of long-term financial assets (quantitative easing) and a big depreciation of the Canadian exchange rate. While helpful, these policies are unlikely to be as effective as the Bank’s traditional strategy for fighting recessions.

The Bank’s benchmark-interest rate is now only 1.75%, well below its level of 4.5% on the eve of the 2007 financial crisis. Long-term interest rates are even lower. There is no reason to expect that these rates will rise substantially in the foreseeable future.

The growth rate of Canadian workers’ productivity is alarmingly low and the working population is aging. These forces are driving the IMF’s forecast of declining growth in Canadian GDP. No one should expect rapid growth in the demand for funds to invest in the real side of the Canadian economy. At the same time, we should expect aging populations around the world to save more, with high demand for safe Canadian and U.S. financial assets.

The Bank of Canada is currently reviewing alternative long-term strategies to deal with the problem of not being able to lower interest rates enough to ease the impact of a recession without having a negative interest rate, this is known as the effective-lower bound problem. The set of alternatives should be expanded to include allowing for wider swings in inflation over time in an effort to fight incipient downturns.

The latter strategy would entail the Bank lowering the threshold for the risk of a downturn that causes it to cut its policy rate. Such a policy shift could temporarily drive inflation above its mid-range target of 2%. But increased risk aversion about an economic downturn is justified given the effective-lower bound problem. If downturns are costlier than they used to be, optimal policy should reflect that fact. And we should remember that the target rate of inflation is a medium-term objective. It’s okay to occasionally be above target as long you’re clear why and what your strategy is for returning to 2% over time.

It would take a long time to convince elected officials of the wisdom of such a substantial change to the Bank of Canada’s current inflation-targeting regime. It would take even longer to credibly communicate a new strategy to the public. We may not have the luxury of time before Canada faces the prospect of a severe recession. 

What should the Bank of Canada do in the face of this challenge?

  1. Decide what to do if there is a severe recessionary shock before its new long-run strategies are in place. The Bank of Canada will likely want to engage in quantitative easing to drive long-run interest rates down.
  2. The Bank needs to communicate its strategy to the public and manage expectations about what it can accomplish with various programs.
  3. During a severe recession the Bank should allow a substantial depreciation of the Canadian dollar which encourages an increase in net exports, boosting the net demand for products produced by Canadians. However, the Bank must be clear that it is not actively intervening in exchange rate markets. 

Exchange rates will probably depreciate more in future recessions. The Bank’s new tools probably won’t be as effective as its old tools, which means future recessions will be larger. Also, quantitative easing will directly contribute to a depreciation of the Canadian dollar. As the Bank pushes down nominal yields on Canadian financial assets, some investors will redirect their investments towards foreign assets. Large-scale purchases of assets by the Bank will also contribute to a depreciation of the Canadian dollar.

Because of its dependence on commodity exports the Canadian economy is particularly sensitive to global downturns. It is incumbent on the Bank to communicate its strategy for dealing with that problem. The public needs to be prepared for the bumpy road ahead that we will almost certainly be travelling along.

Source: Financial Post