Monetary Policy Tools in Canada

• Chapter 16 discusses the tools of monetary policy in Canada, comparing them to those of the Federal Reserve and the European Central Bank.

The Large Value Transfer System (LVTS)

• LVTS is operated by Payments Canada.
• LVTS participants know their large-value transaction balances (over $50,000) in real time.
• LVTS transactions account for less than 1% of total transactions but 87% of the value.
• Settlement occurs at the end of each day using multilateral netting, calculating the net credit or debit position for each participant.
• The LVTS setup reduces systemic risk by ensuring participants can only make payments if they have sufficient settlement balances, posted collateral, or explicit lines of credit.

Non-LVTS (ACSS) Transactions

• These are non-LVTS transactions and paper-based payments such as checks.
• These items clear through the Automated Clearing Settlement System (ACSS), which Payments Canada also operates.
• The ACSS aggregates interbank payments, calculating amounts to be transferred to and from each participant's account with the Bank of Canada.
• Direct Clearers, a subset of LVTS participants, participate directly in the ACSS.

The Bank of Canada's Policy Rate

• The overnight interbank market involves funds with a one-day maturity.
• The overnight interest rate, also known as the reference rate, is the rate at which banks lend overnight funds to each other.
• The policy rate is the target overnight rate announced by the Bank of Canada (BoC), serving as the main target for monetary policy.

The Operating Band for the Overnight Rate

• The Bank of Canada aims to maintain the overnight rate within a band of 50 basis points (0.5%).
• Exceptions included narrowing the band to 25 basis points (0.25%) during the global financial crisis and the COVID-19 pandemic, shifting to a "floor system" in both instances.
• The Bank announces changes to the operating band on eight fixed dates throughout the year.

The Bank of Canada's Standing Facilities

• At the end of each banking day, LVTS participants must bring their settlement balances with the Bank of Canada to zero.
• The Bank of Canada provides standing liquidity facilities to lend reserves, addressing possible negative settlement balances.
• The Bank of Canada absorbs (borrows) any positive settlement balances.
• Participants may use the BoC's lending facility for overnight liquidity in case of a shortage and may also use the deposit facility to make deposits in case of excess liquidity
• The BoC applies a bank rate (50 bps) on the deposit facility and the lending facility.

Demand Curve for Reserves

• LVTS banks both demand and supply reserves.
• The lower the rate paid on reserves, the higher the quantity demanded by banks.
• The demand curve becomes infinitely elastic (flat) when the overnight interest rate equals the rate on reserves.

Supply Curve for Reserves

• The supply has two components: non-borrowed reserves (NBR) and borrowed reserves (BR).
• In the short run, NBR are exogenous (determined by depositors etc.) with the short-run supply curve being vertical at this exogenous quantity.
• Borrowed reserves cost the BoC the bank rate
• The supply curve becomes flat (infinitely elastic) because reserves can be borrowed from the BoC and profitably lent in the market for the overnight rate.

How BoC Limits Fluctuations

• The Bank of Canada's facilitates and procedures implement the operating band for the O/N interest rate.
• A limit for the overnight interest rate between the deposit rate ier = ib-0.50 and the bank rate ib is established.
• The Bank of Canada maintains an inflation target, targeting inflation between 1 and 3 percent, ideally close to 2 percent

How Monetary Policy Affects the Economy

• Changes in the overnight rate influence other interest rates and the exchange rate.
• These, in turn, affect economic activity.
• The Bank of Canada must be able to influence real interest rates and exchange rates.

Three Conventional Monetary Policy Tools

• Open market operations: open market purchases and open market sales
• Settlement Balances Management
• Standing facilities: maintenance of the "corridor" by the standing lending facility and accepting deposits of excess reserves
• These are all referred to as "interest-rate MP tools" which aim to maintain the policy rate, working itself to keep inflation on target.

Open Market Operations

• Open market operations are considered an important monetary policy tool for many central banks
• Open market purchases increase bank reserves, the monetary base, and the money supply and lower short-term interest rates.
• Open market sales decrease bank reserves, the monetary base, and the money supply and raise short-term interest rates.

Open Market Operations in Practice

• The Bank of Canada stopped conducting open market operations in Government T-bills in 1994, and instead uses Repurchase Transactions:
• Special Purchase and Resale Agreements (SPRAs) reduce upward pressure on the overnight interest rate.
• Sale and Repurchase Agreements (SRAs) reduce downward pressure on the overnight rate.
• Special PRAs is when the Bank enters into SPRAs at a price that works out to the target overnight rate.

Settlement Balances Management

• The Bank of Canada also influences the level of settlement balances in the system.
• A target level is typically announced the previous day.
• The Bank neutralizes the impact on settlement balances via open-market buyback operations and SRA operations.
• The Bank make shifts (transfers) of government deposits
• Transfer deposits from banks to Bank of Canada (drawdowns)
• Transfer deposits from Bank of Canada to banks (redeposits)

Bank of Canada Lending

• The Bank of Canada's standing facilities BoC stands ready to lend overnight settlement balances to LVTS participants with negative clearing balances.
• A large increase in demand for reserves shifts demand right, which causes the equilibrium overnight rate to increase.
• The standing lending facility puts a ceiling on the overnight rate.
• By accepting deposits of excess reserves the Bank puts in a floor under the overnight rate.

Beyond MP: BoC as Lender of Last Resort

• The Bank of Canada is important in preventing financial panics.
• The Bank also acts as a lender of last resort, providing emergency lending assistance for a maximum of 6 months.
• These actions prevent bank failures and financial panics.
• The CDIC fund would be a small fraction of all deposits, and CDIC may not guarantee all the deposits.

Nonconventional Monetary Policy Tools

• Conventional policy tools are enough in normal times
• When a financial crisis occurs conventional policy tools may no longer suffice
• Central banks need non-interest-rate tools known as nonconventional monetary policy tools since central banks can become unable to lower interest rates

Tool 1: (Longer-term) Liquidity Provision

• The Bank of Canada introduced new tools during the financial crisis to address system liquidity issues
• Expansion of the Standing Lending Facility- narrow corridor to 25 basis points
• March 31, 2020: new Standing Term Liquidity Facility
• New Lending Programs (including to non-banks)

Tool 2: Large-Scale Asset Purchases

• Open market operations typically involve temporary purchases and sales of government securities
• At the start of the COVID-19 pandemic the BoC initiated a big buying program of Canada bonds
• At least 5 Bln worth per week from April 1, 2020
• In March 2020 it held about 100BIn of Canada Bonds, and balance sheet was 115 Bln
• In December 2020 the balance sheet grew to over 600 Bln

Quantitative Easing Versus Credit Easing

• Expansion of central bank balance sheets is referred to as quantitative easing (QE).
• Will this stimulate the economy in the near term and produce inflation down the road?
• Balance sheet expansion does not necessarily increase the money supply, since excess reserves can increase
• Anyway "higher inflation” does not mean “high inflation” in absolute terms: the counterfactual may have been deflation.
• The Fed's policies were directed not at expanding its balance sheet but rather at credit easing in order to improve the functioning of particular segments of the credit market..
• Liquidity helps unfreeze particular markets and increases demand for certain securities and lowers rates (i.e., long-term).

Tool 3: Forward Guidance

• Central banks can take routes to lower long-term rates and provide further stimulus even when short term interest rates are at zero
• They can make commitments to keep policy rates at zero for an extended period of time, as forward guidance.
• This would lower expectations of future short-term rates.

Tool 4: Negative Interest Rates

• Central banks can charge banks for depositing their funds.
• This encourages banks to lend more & buy more securities.
• Sweden first implemented this in July 2009, followed by Denmark, ECB, Switzerland, and Japan.

Monetary Policy Tools of the Federal Reserve

• Federal Funds Rate
• Open Market Operations
• Discount Lending
• Required Reserves
• Interest on Reserves

The Federal Funds Rate

• The Fed's lending of reserves to banks is called discount window lending
• The interest rate charged banks for these loans is called the discount rate
• The primary indicator of the stance of monetary policy in the United States is the federal funds rate, the interest rate on overnight loans of reserves that banks trade among themselves

Monetary Policy Tools of the European Central Bank

• Open Market operations main refinancing operations and longer-term refinancing operations
• Lending to banks marginal lending facility/marginal lending rate and deposit facility.
• 2% of the total amount of checking deposits and other short-term deposits and interest paid on those deposits.