Bank of Canada asset purchases outpace economic growth amid no recession, no crises
September 18, 2019
Erik Fertsman
The Canadian central bank, the Bank of Canada (BoC), decided
to keep it's "overnight" policy rate steady at 1.75 percent last week. The BoC's job is to achieve full employment and "price stability," and based on the
latest data, unemployment is at historical lows and the consumer price index (CPI) is above 2 percent, the Bank's target. So, it's all hunky dory according to Governor Steven Poloz and his team.
However, this conclusion seems to be at odds with the economic data, given that nominal GDP (economic growth on a year-over-year basis) is hovering at historical lows and is dangerously close to zero. At the same time, the Bank's view that housing, wages, and consumer spending is "strong" when clear weaknesses are evident in these sectors is a head-scratcher.
Statistics Canada just released the latest BoC balance sheet data, and unfortunately there's a few other things we need to highlight about the BoC's performance.
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Total asset growth is outpacing economic growth
Total assets at the central bank now sit around CAD $120 billion. This is up nearly CAD $2 billion since July, or 3.6 percent on a year-over-year basis. Check it out:
One of the problems that can be flagged in the data right away is that, over the last three years, the rate at which the Bank has been growing its balance sheet is consistently outpacing economic growth (nominal GDP). This has negatively influenced the BoC's asset-to-GDP ratio, which rises as the denominator (GDP in dollar terms) lags behind the numerator (assets in dollar terms):
The trend in the BoC's asset-to-GDP ratio is quite revealing, because it demonstrates that the bank's operations, over time, are functioning at a deficit relative to the local economy. This is a large problem now facing the European Central Bank, the Bank of Japan, and the Federal Reserve - all of whom seem to be having trouble with reducing the size of their books relative to the local economy.
Right now it may not be a problem for the BoC, but it can quickly escalate. For example, Canada's banking sector has created a massive stockpile of credit for financial transactions. This includes CAD $1.18 trillion in mortgage credit. If only a tiny fraction of these mortgages become non-performing, then the BoC will need to purchase them through a "quantitative easing" program.
This is becoming a threat to the BoC the more that house prices fall, as is currently the case. And it becomes even more of a risk if economic growth begins to falter. Right now, it's uncomfortably close. The assets supporting mortgages (houses) are marked-to-market, so a contraction in housing prices may seriously increase the risk of these loans. If the economy contracts and people lose their abilities to maintain their mortgage payments, some of the mortgages will turn into non-performing loans.
The BoC would be quickly forced into a situation where it would need to purchase a portion of mortgages held by banks and park them on its balance sheet under a "quantitative easing" program. Otherwise, the banks may refuse to lend any money. For example, if only a generous 1 percent of the mortgage market became non-performing, the BoC would need to buy them up, and that would add about CAD $12 billion onto its books.
If that generous scenario were to happen today, we would see the BoC's balance sheet increase by about 10 percent. To make matters worse, if people are not making payments on their mortgages, it's very likely that the rest of the economy is not doing well, either. Assuming a generous economic growth rate of zero, we could see the BoC's asset-to-GDP ratio increase significantly.
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BoC uses balance sheet to manipulate rates, but it's not doing much for the economy
OK, so there's no crisis to speak of quite yet, so why worry about the balance sheet, then?
A question we need to ask is, whether or not stacking up the balance sheet relative to the economy is worth it outside of a recession or banking crises. The primary reason the Bank buys assets is to influence interest rates - the primary method it uses to reach its inflation goals (aka., the 2 percent target).
So, what's the track record on that?
Rather than looking at the total dollar figure, the above chart shows us nominal changes of two of the largest assets on the BoC's balance sheet: treasury bills and bonds. This allows us to better observe how, exactly, these two assets are going up and down on the balance sheet.
Between May 2017 and May 2018, we can see that the Bank increased its holdings of bonds with maturities of 1 year or more, and it significantly increased its holdings of short-term treasury bills. GDP was moving at a nice pace, so why pile on the assets? That's because inflation was below the 2 percent target.
Between May 2018 and May 2019, the Bank was still coming in shy of the 2 percent inflation target, so it increased its holdings of treasuries even more, but started decreasing its holdings of bonds to compensate the other way a little bit. The result? Inflation bouncing around just below the target, but GDP got slammed.
From this brief look at the data going back the last 3 years, the BoC's policies do not seem to be adequately meeting their goals of inflation at 2 percent. To make matters worse, GDP has been coming in below the rate at which the Bank has been purchasing assets to lower interest rates. This is supposed to "spur the economy."
What we're describing here is not surprising, even to the BoC. The Bank's governing team has come out multiple times
to suggest that interest rates have a limited role to play in economic output.
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BoC overnight rate seems to be following the economy
Since the summer of 2018, the Bank's overnight finance rate has been experiencing decelerating growth on a year-over-year basis. Take a look:
According to the BoC, the Bank fulfills its monetary policy by influencing short-term interest rates. And the primary way it does that is by raising or lowering the "Bank rate" or the price at which the commercial banks borrow and lend funds with one another through the BoC's marketplace. Changes in this rate influence other interest rates, such as the ones the underpin consumer loans and mortgages.
Now, the bank rate in the overnight lending market above (which is followed by other important market rates) seems to be closely following GDP with a lag of about 8 to 9 months. Why is this important? Well, if GDP is trending lower (as has been the case for years) and rates follow the economy (because credit needs to be discounted for people to borrow it), will the Bank keep buying increasingly larger sums of treasury bills and bonds to push down rates? Where does it end?
You can see how, even if there's no emergency measures in the form of quantitative easing programs, this works against the Bank's asset-to-GDP ratio. Lower GDP growth forces the BoC to purchase more assets to lower rates under its current programs, but it has no significant material impact on GDP growth - a true Gordian knot.
Cover image by: Yeshi Kangrang
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