While quantitative easing (QE) programs resulted in significantly lowered bond yields after the financial crisis, the Bank of Canada’s recently announced QE program likely won’t work the same way, says a report from CIBC Capital Markets published on Monday.
QE programs act to lower interest rates by depressing term premiums on longer-term government bonds, as central banks buy these bonds and thus remove supply.
In the last week of March, the Bank of Canada (BoC) announced a debt purchasing program with a minimum target of $5 billion per week. However, in contrast to the Fed’s QE program following the financial crisis, the BoC’s bond purchases are focused across the yield curve, not solely on long bonds, as Canada’s central bank aims to add liquidity to problem areas of the market.
“So far, the [central] bank has purchased a majority of bonds at the short end of the curve,” the CIBC report said. “That’s a key point of differentiation between what the Bank of Canada is conducting and the standard definition of quantitative easing.”
Even traditional QE would likely not be effective at lowering borrowing rates much, because research shows that direct effects of QE programs on term premiums in small open economies are relatively small.
“Much of the movements in Canadian bond yields are dictated by those in larger economies,” the report said.
Regardless of these considerations, lowering borrowing rates via QE isn’t the most important task for monetary policymakers, the report said.
Instead, considering that yields on government debt fell dramatically ahead of the program’s announcement, “the immediate challenge is to see those prior declines transmitted to the private sector,” it said.
That seems to be happening to some extent, with key funding markets showing fewer signs of stress and borrowing rates starting to drop.
The report also considered the relationship between QE and fiscal spending, noting that, after the crisis starts to abate, large fiscal stimulus won’t push the BoC to raise rates. (In normal times when unemployment is low, government spending crowds out private investment, because central banks must raise rates to keep the economy from overheating.)
Tighter monetary policy won’t be needed because the economy will be operating well below capacity — likely more than 4% below at year-end, CIBC forecasted.
Key to kickstarting the pace of acceleration will be borrowers’ appetites, which likely won’t be great.
“Even after the shutdowns, many businesses and households will already have taken on additional debt to weather the storm and will therefore likely be restrained in terms of spending and investment plans,” the report said.
As such, more fiscal stimulus will be required to support economic recovery later this year — and that’s where the benefit of QE comes in.
While Canada’s QE program likely won’t work in the typical way by significantly lowering longer-term yields, as well as depressing the exchange rate, it will likely be best suited for “keeping a lid on the government’s borrowing costs at a time when fiscal policy has the most scope to provide stimulus during the recovery,” the report said.
Further details on the BoC’s bond-buying measures could be provided at its next rate announcement on Wednesday.
In its latest weekly economics report, Scotiabank Economics said the BoC’s stimulus work is “by no means done as the pace of its actions continue to slip behind the Federal Reserve’s.”
Among the options to apply more stimulus are “broadening targeted markets and firming guidance surrounding open-ended bond purchases while nevertheless retaining guidance that 0.25% is the effective policy rate floor,” the Scotiabank report said. (The BoC has said that its current overnight rate of 0.25% is the effective lower bound on rates.)
For targeted markets, one option is to buy provincials, the spreads of which remain stubbornly high, it said. Regarding guidance for bond buying, Scotiabank forecast that QE could continue until year-end 2020 or mid-2021.
If the BoC were to move forward with buying provincials and extending bond buying, “potentially hundreds more billions of dollars of stimulus could be added into the Canadian financial system in an effort to further force monetary stimulus through the cracks in the financial system,” the Scotiabank report said.