Quantitative Easing: A Medicine That Hurts

Canadian Money Queen by GoodNCrazy is licensed under CC BY 2.0

Stringent containment measures have played a significant role in enabling governments worldwide to curtail the spread of the novel coronavirus. Coinciding with these restrictions have been large reductions in the supply of goods and services due to the economy's reduced production capacity, and sharp declines in the spending power of “millions of Canadians who have either lost their jobs or seen their hours scaled back”. This upheaval in consumer and producer behaviour has had substantial economic consequences, warranting a rethink of how best to use macroeconomic policy tools to support Canadians in the midst of the current crisis. The Bank of Canada’s October 2020 Monetary Policy Report outlines the use of monetary policy measures to facilitate the economic and financial recovery of Canadians. 

The Bank of Canada is the nation's central bank, and its primary responsibilities are to oversee Canada’s monetary policy, financial system, currency, and funds management. Monetary policy is the process by which the “supply of money circulating in the economy” is influenced in order to “keep inflation low and stable.” The Bank announced two ways in which they intend on using this economic tool to alleviate the financial burden of the pandemic and achieve an inflation target of two per cent. The proposed initiatives will likely stimulate economic activity. However, experts warn that such tools, though necessary, could potentially make the financial system more vulnerable to future economic shocks. The following is an overview of the proposed monetary policy initiatives by the Bank of Canada. 

Firstly, they will continue to maintain the overnight interest rate at the “effective lower bound”. Financial institutions borrow and lend funds amongst themselves on a daily basis, and the central bank sets a target rate for this borrowing and lending by announcing the range of interest rates at which these transactions can take place. These overnight rates influence other interest rates in the economy including consumer loans and mortgages. Thus, artificially keeping these short-term rates low results in lower costs of borrowing money for consumers in general. 

Secondly, the Bank of Canada has announced that it will reinforce the above policy by recalibrating its quantitative easing program. Quantitative easing is when the central bank increases the supply of money in the economy by purchasing government bonds and other securities. An increase in money supply leads to a decrease in the cost of money, which would subsequently result in lower interest rates. In theory, this would provide banks with more liquidity, leading to increased lending and investment activities, thereby stimulating the economy. The Bank of Canada aims to do this by purchasing “longer-maturity bonds”, as they influence long-term borrowing rates and thus are most relevant to households and businesses. 

The proposed initiatives are likely to stimulate long-term economic growth. Current measures of inflation are below two per cent, which is due to the fact that the economy’s demand has fallen by more than its supply.   Deflation is undesired, as it decreases production levels and wages which coincides with reductions in the demand for goods and services in the economy. Thus, achieving the low and stable inflation rate goal of two per cent is important for pandemic recovery efforts, as it allows the economy to “expand at a sustainable pace, generating higher incomes and new jobs.” Lower interest rates derived from both the lower bound overnight rate and the quantitative easing program would make borrowing cheaper for households and businesses, subsequently incentivizing spending. In the long-run, this increased demand would create inflationary pressure on the economy, causing inflation rates to reach the desired level of two per cent, which would create a climate fit for economic growth.

However, experts claim that future financial system vulnerabilities can arise from these policies if not careful. The course of the economic recovery remains uncertain and is highly dependent on the ongoing developments of the pandemic. This uncertainty also derives from a lag between when the policy is implemented and its realization. It takes several financial quarters for monetary policy to start having an impact on the economy, whether that be negative or positive. Moreover, 2020 saw an “unusually large jump in the savings rate” with household precautionary savings having increased significantly at the onset of the pandemic. Thus, although the proposed initiatives should theoretically stimulate demand, consumer and business confidence and behaviour will remain dependent on the trajectory that COVID-19 takes in the coming months and years. 

Furthermore, the Governor of the Bank of Canada, Tiff Macklem, claims that “higher debt levels among Canadian households, businesses and governments” is another current vulnerability that the Canadian economy faces. Though the low interest rates are set to encourage higher levels of borrowing, this can be problematic should households start taking on excessive amounts of debt relative to their income. National Bank Financial reiterates these concerns, observing that the Bank’s quantitative easing program has caused distortions in the economy, such as tighter liquidity in the secondary market for securities, and notes that this is likely to worsen over time. This combination of increased debt and economic uncertainty could lead to dire repercussions if pandemic conditions were to intensify, such as “increased risk premiums” and “tighter financial conditions.” 

The measures taken to prevent the spread of COVID-19 have had substantial effects on global economies. Consumer and producer behaviours have adjusted to the current economic realities that have been created by the pandemic, and as such, the nature of economic policies have also adjusted accordingly. These interventions aim to bolster domestic spending and investments, and range from direct changes to the overnight interest rate, to the use of quantitative easing. The Bank of Canada’s proposed monetary tools will work to stabilize the financial market and pursue long-term growth, however, one has to keep in mind the potential risks that might arise in the future.