A Different Kind of Thinking

by Inya Ivkovic, MA

Wednesday, I wrote about central banks finding themselves lost without their precious inflation-centered monetary policy, arguing it is mostly designed for “peace time” policymakers and largely ineffective at times of crises and extreme volatility. In this article, I’d like to put the spotlight on one central bank, which, for better or worse, is trying to break away from the herd mentality. My readers shouldn’t be surprised when I tell them it is the Bank of Canada again that is travelling on a different path.

By now, it doesn’t take a rocket scientist to realize that manipulating short-term interest rates is not enough to deal with the breadth and depth of the current recession. As a result, far too many major central banks have resorted to their second-best option, which is to keep money-printing presses work around the clock. But not the Bank of Canada.

Instead, Canada’s central bank joined a tiny club of central banks (Norway, Sweden and New Zealand are members, too), saying clearly and publicly that it will keep its interest rates very low, as close to zero as practicable, but for a relatively limited period of time of about a year, give or take. No fiddling in between and no monthly or weekly shows before the public in almost desperate attempts to convince us that there is a purpose to the existence of a central bank after all.

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The plan for full disclosure well in advance of the key monetary policy decision focuses on boosting investor and consumer confidence, promising that low rates are here to stay and, only as a secondary goal, the aim is to anchor inflation and moderate extreme volatility in the credit markets. And while there is little that can be done about the long-term confidence, current research shows that, at least in the near term, such a benign and unobtrusive method at least provides an impression of stability amidst the turmoil.

Of course, there are strings attached. There is no such thing as a strategy without risk. For now, the public seems content that at least there is a semblance of order in the credit markets. But should the Bank of Canada decide to change direction sooner than planned and communicated initially, it could create even more volatility as opposed to mollifying it. Additionally, such unwavering commitment to ultra-reduced interest rates may further erode confidence if investors and consumers are still not enticed to spend more and put more back into the economy.

At the heart of the issue is understanding that consumers, investors and markets need time to digest information, particularly in these volatile times. I believe that the myth of old, whereby the market is quick to absorb any new information, no longer holds true. Markets are extremely wary now, distrustful of any long-term decisions, and their very “wait-and-see” approach is what is making most policy decisions, including monetary policies, difficult to predict and ultimately even doomed to failure.

Why? With decisions based on estimates and expectations, there are always strings attached, or conditions. There is always that darn awful “if” clause that makes it so difficult to understand why one policy decision works better than the other. This is also referred to as “conditionality.”

Here is a recent example of how things can go wrong. About a decade ago, just before the ripple effect of the Asian financial crisis hit Canada’s shores, the Bank of Canada, suffering from an abrupt attempt at transparency, publicly announced that it would keep interest rates low if nothing else shocks the economy further. Of course, the markets had fits of their own and they traded as if it was the central bank talking downwind as usual. And when the Asian tsunami finally hit Canada, the country’s currency spiraled down the toilet and the central bank felt it had no other choice but to defend the Canadian dollar by raising interest rates a full 100 basis points. But, as far as the markets were concerned, the Bank of Canada went back on its word, loads of money was lost and there were no happy campers in sight. The response from the central bank was to revert back to the language of hints and innuendos that could mean anything and usually meant little or nothing.

Today, the Bank of Canada is transparent again and it makes me wonder if the conditionality surrounding its monetary policy today has really changed all that much. Probably not, but something else is different. This time around, the Bank of Canada has taken its transparency to a whole new level, trying to educate not just the general public, but the markets as well about how complex and uncertain any attempt to quantify and underpin interest rate commitments is. Communicating clearly that interest rate commitments have strings attached leaves those who ignore them to tread ahead at their own peril.

Will Canada be successful in explaining to people that keeping interest rates low for a year is not a guarantee, but nothing more than a contingent forecast? Why wouldn’t it be? Such an approach worked really well for Norway and there is no reason it shouldn’t work so for Canada, too. And as for the “conditionality” part of this story, investors and consumers would do well to remember that interest rates will be ultra low for a limited time and, if they wish to benefit from them, now’s as good a time as any.