Out of options, Bank considers printing money

Stunned by how badly the Canadian economy is performing, the Bank of Canada stated in its latest monetary policy report that is looking at fresh options to stimulate the economy, including quantitative easing — essentially plain old money printing.

Canada has suffered a 7.3% contraction — the single largest quarterly decline in GDP since 1961 and far worse than the Bank’s earlier forecasts. The Bank concedes that further actions will have to be taken to get the economy back on track for a newly revised projection that won’t see Canada pushing its economic capacity until 2011.

“In the January update, the Bank projected a sharp recession in Canada, followed by a relatively muted recovery starting in the third quarter of this year. As a result of the more severe, synchronized nature of the global downturn, the recession in Canada is even deeper than anticipated,” the Bank reports.

The Bank had been expecting Canada to post a 2.3% decrease in annual GDP in 2009, but last quarter’s devastating contraction has Canada on pace to see an annual decline of 3.4%, placing the economy on a more severe downward trajectory than that of the U.S.

As a result, deflation is taking hold of the Canadian economy, as staple goods, automobiles and resources continue to see price declines.

Few tools left to fight deflation

The report notes that core inflation is expected to diminish through 2009, gradually returning to its 2% target in the third quarter of 2011 as aggregate supply and demand return to balance. In the meantime, total consumer price index inflation is expected to trough at -0.8% in the third quarter of 2009 and return to target in the third quarter of 2011.

The Bank’s basic and most effective weapon to fight deflation is to lower interest rates. It’s done so, aggressively, since December 2007 by cutting rates by a whopping 425 basis points. With an overnight target rate of 0.25 basis points, there is essentially no ammunition left.

In the report, the Bank points out that is will be looking at alternative stimulus measures, including quantitative easing policies, which have been used by the U.S. Federal Reserve. In the case of the U.S., the Federal Reserve has committed more than $300 billion to buy U.S. Treasuries as a way to bring down bond spreads and get institutions lending to each other.

Ironically, while the Bank is openly musing about adopting quantitative easing, it refused to commit to a such a policy or even suggest what assets it would be looking to buy, which is sending bond prices lower. The forward-looking bond market had already priced in a strong possibility of the Bank becoming a captive buyer of Canadian bonds.

Bond managers don’t expect easing soon

“Reaction in the markets was twofold. The dollar gained a cent on the announcement that interest rates will probably stay higher in Canada compared to other countries, like the U.S. market. The bond market was expecting some quantitative easing, they were expecting that Bank would announce it is getting directly involved in purchasing bonds,” says Jean Charbonneau, senior vice-president of fixed income and a portfolio manager with AGF Funds. “By putting quantitative easing on hold for now, the yields on 10-year Canadian bonds lost almost 10 basis points on the announcement — which was a spectacular drop.”

Fixed income specialist, Darcy Briggs, a vice-president and portfolio manager with Bissett Investment Management, says Canada’s ability to combat deflation is limited compared to the Federal Reserve. He expects the Bank will hold off on printing money unless it becomes evident the Fed’s quantitative easing policies aren’t working.

“I don’t anticipate bonds are going to spike higher. The Bank of Canada is not a huge rush to jump into quantitative easing, because while they see our economic conditions are pretty dismal, our economy is pretty much joined at the hip with global and U.S. economic fortunes. Unless those economies turn around, there is no reason for yields to spike,” he says. “Today, the Bank tentatively committed to quantitative easing if necessary. It’s waiting to see how the quantitative easing is going to transpire in the U.S. and have the Fed do some of the heavy lifting.”

According to Briggs, quantitative easing is working in that it seems to have capped the upper trading boundaries on U.S. Treasuries. You don’t necessarily have to buy bonds to do this. The Bank can also create a trading range by announcing it will stand pat on rates for a predetermined period of time.

“[U.S. tTreasuries] are effectively in a trading range now. The Fed wanted to put an upper bound on rates, which looks like it’s about 3% on a 10-year Treasury in the U.S.,” he says. “Another part of quantitative easing is moral suasion, where the Bank makes a commitment to hold rates at a certain level. This is what the Bank of Canada did in its monetary policy report. They have somewhat engaged in a mild form of quantitative easing by issuing that statement.”

Briggs adds, “Holding rates is contingent on inflation. The Bank has said they are going to hold rates at the current levels until mid-2010, and they are not expecting inflation to move ahead until that point in time, and they’re not expecting inflation to hit the mid-point of their range until 2011.”

Charbonneau says that Bank Governor Mark Carney’s decision to come out and say rates won’t change until 2010 is unprecedented.

“The Bank appears to be playing on transparency as a policy alternative to rate cutting rather than anything else,” he says. “We’ve never seen any central bank come out and say rates won’t go up over the next year. That’s a completely new way of expressing transparency.”

(04/23/09)