Monetary Policy Tools in Canada - Chapter 16

Chapter 16: Tools of Monetary Policy

• Learning Objectives (1 of 2):

  • Understand the framework of monetary policy implementation in Canada, including the LVTS, overnight interest rate target and operating band, and the Bank of Canada's standing liquidity facilities.
  • Learn about the market for reserves and how changes in monetary policy affect overnight interest rates.
  • Understand the Bank of Canada's approach to monetary policy.

• Learning Objectives (2 of 2):

  • Summarize the implementation and strengths/weaknesses of conventional monetary policy tools.
  • Learn about key monetary policy tools used when conventional policy is ineffective.
  • Identify differences and similarities between the Bank of Canada's monetary policy tools and those of the Federal Reserve and the European Central Bank.

The Large Value Transfer System (LVTS)

• Operated by Payments Canada
• LVTS participants know the balance of large-value transactions (over $50,000) in real time.
• LVTS transactions account for less than 1% of the total transactions but 87% of the value.
• Settlement at the end of each day is multilateral, calculating only the net credit/debit position of each participant.

Systemic Risk and the LVTS

• The inability of one financial institution to fulfil its payment obligations risks the entire payment system.
• LVTS setup minimizes this systemic risk.
• Participants can make payments only if they have positive settlement balances with the Bank of Canada or posted collateral (such as T-bills and bonds), or have explicit lines of credit with other LVTS participants.

Non-LVTS (ACSS) Transactions

• These are paper-based payment items (e.g., cheques).
• Cleared via the Automated Clearing Settlement System (ACSS), an electronic payments system run by Payments Canada.
• ACSS aggregates interbank payments and calculates net amounts transferred between participants and the Bank of Canada.
• Direct Clearers are a subset of LVTS participants involved directly in ACSS transactions.

The Bank of Canada's Policy Rate

• Refers to the target for the overnight interbank rate.
• Announced by the Bank of Canada (BoC) during monetary policy implementation.
• The overnight interbank market is the market for funds with a maturity of 1 day.
• The reference rate is the overnight interest rate at which banks borrow and lend overnight funds to each other.

The Operating Band for the Overnight Rate

• The target is to maintain the overnight rate within a 50 basis point band (1/2 of 1%).
• There are exceptions to this band sometimes, such as during the global financial crisis and the COVID-19 pandemic. During these times, the operating band was narrowed.
• The Bank of Canada uses a "floor system" in some circumstances.

The Bank of Canada's Standing Facilities

• At the end of each banking day, LVTS participants must bring their settlement balances with the BoC to zero.
• The BoC has standing liquidity facilities:
  • Lending reserves to bring negative settlement balances of a bank to zero
  • Absorbing (borrowing) any positive settlement balances of a bank
• Ordinarily, excess reserves are best lent out in the overnight market and if there's a shortage banks borrow in the overnight market for reserves.

The Bank of Canada's Standing Facilities (2 of 2)

• The LVTS participant can use the lending facility to get overnight liquidity when necessary.
• The deposit facility can be used to deposit excess liquidity.
• The rates for positive and negative settlement balances are clearly defined.
• The bank rate applied to the deposit facility is 50 bps.
• The bank rate on the lending facility is also defined..

Equilibrium in the Market for Reserves

• Equilibrium occurs at the intersection of the supply and demand curves for reserves.
• Excess supply of reserves leads to a lower overnight interest rate.
• Excess demand for reserves leads to a higher overnight interest rate.
• The demand curve for reserves is typically flat, reflecting the unlimited amount of reserves banks will borrow if the cost is less than the rate payable on those reserves.
• The supply curve is determined by the amount of nonborrowed reserves and the cost of borrowed reserves.

How the BoC Limits Fluctuations in the Overnight Interest Rate

• By using the standing facilities and operating procedures to set limits for the overnight interest rate between a deposit rate and a bank rate floor and ceiling.

The BoC's Approach to Monetary Policy

• Maintaining an inflation target of between 1% and 3%, preferably close to 2%.
• Price level targeting is an alternative approach.

How Monetary Policy Affects the Economy

• Changes in the overnight rate affect other interest rates and exchange rates, which impacts economic activity.

The Three Conventional Monetary Policy Tools

• Open market operations (buying/selling government securities)
• Settlement balances management (adjusting government deposits)
• Standing facilities (lending/borrowing reserves at set rates)

Open Market Operations

• Open market purchases expand bank reserves, lower short-term interest rates, and increase money supply.
• Open market sales shrink bank reserves, raise short-term interest rates, and reduce money supply.
• Repurchase agreements (repos) and Special Purchase and Resale Agreements (SPRAs) is the Bank's modern open market operations approach.
  • These tools are used to address upward or downward pressures on overnight interest rates

Settlement Balances Management

• The BoC adjusts government deposits to influence the level of settlement balances. This is often done via open market operations and Special Purchase and Resale Agreements (SPRAs).

Nonconventional Monetary Policy Tools

• Conventional tools are sometimes insufficient during financial crises.
• Zero-lower-bound constraint, where interest rates are already at or near zero, may require additional tools.
• Banks may need non-interest rate tools, or nonconventional monetary policy tools

Tool 1: (Longer-term) Liquidity Provision

• The Canadian central bank creates tools in response to financial crises to assist with liquidity issues.
• These tools included expanding the Standing Lending Facility, narrowing the corridor, and introducing the Standing Term Liquidity Facility and New Lending Programs for non-banks.

Tool 2: Large-Scale Asset Purchases

• Large-scale purchases of government securities, such as in response to the COVID-19 pandemic, to inject liquidity into the financial system.

Quantitative Easing Versus Credit Easing

• Quantitative easing increases central bank balance sheets through unconventional monetary policy Tools.
• Credit easing is aimed at altering the composition of the central bank's balance sheet, and improving functioning of particular sections of the credit markets.
• Liquidity support helps unfreeze markets and reduce long-term rates.

Tool 3: Forward Guidance and the Commitment to Future Policy Actions

• Central banks can commit to keeping policy rates at zero for an extended period to lower long-term rates and provide stimulus.

Tool 4: Negative Interest Rates on Reserves

• Central banks can charge banks for holding reserves to encourage lending and security purchases.

Monetary Policy Tools of the Federal Reserve

• The Federal Reserve (Fed) uses various tools such as the federal funds rate, open market operations, discount lending, required reserves, and interest on reserves.