chapter 17 The Framework for the Implementation of Monetary Policy and the Tools of Monetary Policy

Copyright © 2002 Pearson Education Canada Inc Overview So far we derived a multiplicative relation between M and MB M = m  MB and discussed three monetary policy tools that the Bank of Canada can use to manipulate i and M. These tools are open market operations Bank of Canada advances, and government deposit shifting In recent years, however, the Bank conducts policy by setting an operating band for the overnight interest rate i or and targeting i or at the midpoint of the band. In doing so, the Bank permits M to do whatever necessary to keep i or on target.

Copyright © 2002 Pearson Education Canada Inc The Role of Money Before we go on, we have to clear up a potential confusion: Although the Bank of Canada can control both i and M, it would be wrong to view i and M as distinct policy instruments. The reason is that a given i policy has to be supported by a given M policy. That is, the Bank influences i by adjusting M. To put it differently, i is the price of M and the Bank affects the price of M (that is, the interest rate) by controlling the quantity of money. With this in mind, let’s discuss the institutional framework within which the Bank conducts monetary policy.

Copyright © 2002 Pearson Education Canada Inc The Large Value Transfer System, LVTS The LVTS (introduced on February 4, 1999) is an electronic, real-time net settlement network, designed to provide immediate finality and settlement to time-critical transactions LVTS participants know in real time their large-value, wholesale transactions (over $50,000). Although these transactions account for less than 1% of the total number of transactions, they account for about 94% of the value of transactions in Canada The LVTS uses multilateral netting — only the net credit or debit position of each participant vis-à-vis all other participants is calculated for settlement

Copyright © 2002 Pearson Education Canada Inc LVTS Participants As of January 2001, in addition to the Bank of Canada, there were 13 LVTS participants — members of the CPA who participate in the LVTS and maintain a settlement account at the Bank of Canada. These are: Big Six Alberta Treasury Branches Bank of America Canada Banque Nationale de Paris Canada La Caisse centrale Desjardins du Québec Credit Union Central of Canada HSBC Bank Canada Laurentian Bank of Canada

Copyright © 2002 Pearson Education Canada Inc Systemic Risk The LVTS has been put in place to eliminate systemic risk. In fact, participants can make a payment only if they have positive settlement balances in their accounts with the Bank of Canada, posted collateral (such as T-bills and bonds), or explicit lines of credit with other LVTS participants

Copyright © 2002 Pearson Education Canada Inc Real-Time Settlement Systems in Other Countries CountryYear introduced U.S. (Fedwire)1918 Sweden 1986 Germany and Switzerland 1987 Japan 1988 Italy 1989 Belgium and U.K France, Hong Kong, and Netherlands1997 The LVTS has been put in place in order to eliminate systemic risk — the risk to the entire payments system due to the inability of one bank to fulfill its payment obligations in a timely fashion. Of, course it is not just Canada that is concerned about systemic risk.

Copyright © 2002 Pearson Education Canada Inc Small Value Transactions and the ACSS These are non-LVTS (paper-based) payment items, such as cheques These items are cleared through the Automated Clearing Settlement System (ACSS), an electronic payments system also operated by the CPA The ACSS aggregates interbank payments and calculates the net amounts to be transferred from and to each participant's settlement account with the Bank of Canada The Bank of Canada completes the settlement retroactively the next day (at midday) through the LVTS

Copyright © 2002 Pearson Education Canada Inc Direct and Indirect Clearers Direct Clearers: The subset of LVTS participants who participate directly in the ACSS and are known as direct clearers Indirect Clearers: These are the deposit-taking financial institutions that are members of the CPA but do not have a clearing account with the Bank of Canada. Indirect clearers hold deposits in direct clearers in exchange for a variety of services, including cheque clearing, foreign exchange transactions, and help with securities purchases

Copyright © 2002 Pearson Education Canada Inc The Operating Band of 50 Basis Points for the Overnight Interest Rate The upper limit defines the bank rate — the rate the Bank charges LVTS participants that require an overdraft loan to cover negative settlement balances The lower limit is the rate the Bank pays to LVTS participants with positive settlement balances

Copyright © 2002 Pearson Education Canada Inc The Bank’s Standing Liquidity Facilities At the end of each day, each LVTS participant must bring its settlement balance with the Bank close to zero. The Bank therefore stands ready (we call this standing liquidity facilities) to provide or absorb liquidity with an overnight duration to participants facing unforeseen liquidity shocks. The initiative is on the side of the LVTS participant. A participant may use the Bank’s lending facility to obtain (against eligible collateral) overnight liquidity in case of a shortage, or it may use the deposit facility to make deposits in case of excess liquidity.

Copyright © 2002 Pearson Education Canada Inc The Bank’s Standing Liquidity Facilities (continued) Although the Bank’s standing facilities provide an insurance mechanism for banks, they do so at penalty rates: Regarding LVTS settlements, the Bank charges i b on LVTS collateralized advances and pays i b less 50 basis points on LVTS positive balances. Regarding ACSS settlements, the Bank charges i b plus 150 basis points on ACSS collateralized advances and pays i b less 150 basis points on ACSS positive balances. So the rate spread at the Bank’s standing facilities for ACSS balances is 250 basis points wider than for LVTS balances.

Copyright © 2002 Pearson Education Canada Inc Pre-settlement Trading Participants can reduce the costs of either positive or negative positions by trading with each other in the LVTS pre- settlement period at the end of the day (6:00-6:30 p.m.). In fact, the typical bid-ask spread on overnight funds in the interbank market has been less than 1/8%, much less than the 50 basis points on LVTS balances and 300 basis points on ACSS balances. Hence, participants can adjust positions with each other in the overnight market at a better return than can be achieved at the Bank’s standing facilities.

Copyright © 2002 Pearson Education Canada Inc The Market Timetable

Copyright © 2002 Pearson Education Canada Inc The Bank’s Implementation of the Operating Band for i or If i or  towards the upper limit, then the Bank will lend at i b to put a ceiling on i or If i or  towards the lower limit, then the Bank will accept deposits at i b less 50 basis points, to put a floor on i or

Copyright © 2002 Pearson Education Canada Inc The Market for Settlement Balances and i or Demand Curve for Settlement Balances 1. At i b, the demand curve is horizontal, since the demand for negative settlement balances will be indefinitely large 2. At i b less 50 basis points, the demand curve is also horizontal, since the demand for positive settlement balances would also be indefinitely large 3. At rates within the band, the demand for settlement balances is zero Supply Curve for Settlement Balances 1. Bank normally targets a daily level of settlement balances of zero 2. Supply curve is a vertical line at the zero quantity Market Equilibrium 1.Occurs at the intersection of the vertical supply curve and the vertical part of the demand curve at the zero quantity 2.Equilibrium i or could be anywhere within the operating band

Copyright © 2002 Pearson Education Canada Inc Supply and Demand for Settlement Balances The equilibrium i or is indeterminate and could be anywhere within the 50-basis- point band. This means that the actual i or will be somewhat different from the target i or indicated at the start of the banking day by the Bank.

Copyright © 2002 Pearson Education Canada Inc The Bank’s Current Approach to Monetary Policy In February 1991, the Bank’s governor and the minister of finance announced a series of declining  targets. The targets were 3% by the end of 1992, falling to 2% by the end of 1995, to remain within a range of 1%-3% thereafter. The 1%-3% target range for  was renewed in December 1995, in early 1998, and again in May 2001, to apply until the end of The goal of the Bank’s current policy is to keep  at the midpoint of the  target range, 2%.

Copyright © 2002 Pearson Education Canada Inc How the Bank Keeps  From Falling Below the Target Range The Bank expects the economy to slow down and wishes to ease monetary conditions. It lowers the operating band for i or, thereby encouraging banks to borrow R either from each other at i or or from the Bank at i b The  in i and E lead to an  in M, AD, and P, thereby preventing  from falling below the target range.

Copyright © 2002 Pearson Education Canada Inc How the Bank Keeps  From Moving Above the Target Range The Bank expects the economy to be exceeding its capacity in the future and wishes to slow it down. It raises the operating band for i or in order to prevent inflationary pressures from building. The  in i and E lead to an  in M, AD, and P, thereby preventing  from moving above the target range.

Copyright © 2002 Pearson Education Canada Inc The Bank’s Influence on Long-Term Interest Rates By changing the operating band for i or the Bank sends a signal regarding the direction that it would like i and M to take. A rise in the band and thus i b is a signal that the Bank would like to see  i and  M in the economy. A fall in the band is a signal that the Bank would like  i and  M. However, the Bank’s direct influence on long-term rates diminishes as the time period . Long-term rates can be either higher or lower than short-term rates depending on expectations about  and the level of short-term rates in the future, the relative balance between the demand for and supply of loanable funds, the level of i in the U. S., and the relative stance of monetary policies in the two countries.

Copyright © 2002 Pearson Education Canada Inc Open Market Operations Two Types 1.Dynamic: Meant to change MB 2.Defensive: Meant to offset other factors affecting MB Advantages of Open Market Operations 1.Bank has complete control 2.Flexible and precise 3.Easily reversed 4.Implemented quickly

Copyright © 2002 Pearson Education Canada Inc SPRAs and SRAs Over the years, the Bank introduced additional tools in its conduct of monetary policy. 1.In 1985, the Bank introduced repos, which in Canada are known as Special Purchase and Resale Agreements (SPRAs) 2.In 1986, the Bank introduced reverse repos, known in Canada as Sale and Repurchase Agreements (SRAs) By 1994, the Bank stopped conducting open market operations in government of Canada T-bills and bonds and its most common operations since then have been repurchase transactions, either SPRAs of SRAs. SPRAs and SRAs, are conducted with primary dealers (formerly known as jobbers) — the Big Six and the major investment dealers.

Copyright © 2002 Pearson Education Canada Inc The Bank’s Use of SPRAs to Reinforce the Target i or If overnight funds are traded at a rate higher than the target i or, the Bank enters into SPRAs at a price that works out to the target i or. Bank of Canada Assets Liabilities SPRAs+100 Settlement Balances +100 Direct Clearers Assets Liabilities Settlement Balances +100 SPRAs+100 Hence, SPRAs relieve undesired upward pressure on i or

Copyright © 2002 Pearson Education Canada Inc The Bank’s Use of SRAs to Reinforce the Target i or If overnight funds are traded at a rate below the target rate, the Bank enters into SRAs, at a price that works out to the target i or Bank of Canada Assets Liabilities Settlement Balances SRAs +100 Direct Clearers Assets Liabilities Settlement Balances -100 SRAs +100 Hence, SRAs alleviate undesired downward pressure on i or

Copyright © 2002 Pearson Education Canada Inc Bank of Canada Lending (Advances) Two Types 1.Standing Liquidity Facility, to reinforce the operating band for i or 2.Last Resort Lending Lender of Last Resort Function 1.To prevent banking panics CDIC fund not big enough Examples: Canadian Commercial Bank and Northland Bank 2.To prevent nonbank financial panics Examples: 1987 ‘Black Monday’ stock market crash Announcement Effect 1.Problem: False signals

Copyright © 2002 Pearson Education Canada Inc Bank of Canada Advances to Members of the CPA With the failure of the Canadian Commercial and Northland banks in 1985, rumours of trouble led to large deposit withdrawals from the Bank of British Columbia, Mercantile Bank, and Continental Bank. By the time Mercantile was acquired by the National Bank of Canada, Bank of British Columbia by the Hong Kong Bank of Canada, and Continental by Lloyds Bank of Canada, the Bank of Canada lent over $5 billion.

Copyright © 2002 Pearson Education Canada Inc Lending Policy Advantages 1.Lender of Last Resort Role Disadvantages 1.Confusion interpreting bank rate changes 2.Fluctuations in advances cause unintended fluctuations in money supply 3.Not fully controlled by Bank Proposed Reforms 1.Abolish central bank lending (Milton Friedman) A.Eliminates fluctuations in M s B.However, lose lender of last resort role 2.Tie bank rate to market rate A.i – i b = constant, so fewer fluctuations of A and M s B.Easier administration C.No false announcement signals

Copyright © 2002 Pearson Education Canada Inc Should i b be Tied to a Market Interest Rate? For most of the last two decades, the Bank of Canada operated under a floating bank rate regime. That is, i b was tied to a specific market interest rate. For example, from March 1980 to February 1996, i b was set each week at 25 basis points above the average 3-month T-bill rate. In February 1996 the Bank switched to a fixed bank rate regime, with i b being the upper limit of the operating band for i or. Moreover, in December 2000, the Bank introduced a system of eight fixed dates throughout the year for announcing changes (if any) to i b, keeping the option to act between the fixed dates in extraordinary circumstances. Figure 17-7 shows the spread between i b and i or since 1975.

Copyright © 2002 Pearson Education Canada Inc Spread Between i b and i or

Copyright © 2002 Pearson Education Canada Inc The U.S. Fed’s Discount Rate i d In contrast to the Bank of Canada, the U.S. Federal Reserve does not tie the discount rate to a market rate of interest, although it pursues a policy that is consistent with a floating bank rate regime. That is, the Fed does not let i d move too far from market rates because it does not want discount loans to get out of control. Moreover, unlike the Bank, the Fed operates under a system of ten fixed dates throughout the year for announcing changes (if any) to i d. There is no correlation between the Bank of Canada’s eight pre- set announcement dates for i b changes with those of the Fed’s for i d changes.

Copyright © 2002 Pearson Education Canada Inc Advantages of a Flexible i b Regime Many economists support a floating bank rate regime. They argue that by tying i b to a market interest rate (such as the 3-month T- bill rate): the Bank of Canada can continue to perform its role as lender of last resort. most fluctuations between i b and market rates are eliminated. In fact, i – i b = constant, so fewer fluctuations of A and M. there is easier administration of the discount window, there are no false signals about the intentions of the central bank, and hence any possible announcement effects disappear.

Copyright © 2002 Pearson Education Canada Inc Advantages of a Fixed i b Regime Other economists oppose a flexible i b because they think that keeping i b fixed when market rates change would  fluctuations in market rates. For example, keeping i b fixed when market rates  would  A and M, possibly countering some of the  in market interest rates. The most important advantage, however, of a fixed i b regime is that the Bank of Canada can signal its intentions about future monetary policy. For example, if the Bank wants to slow the expansion of the economy by  the target i or, it can amplify the announcement by also  i b. The problem is that i b changes can be subject to misinterpretation.

Copyright © 2002 Pearson Education Canada Inc False Signals and Announcement Effects If, for example, i or  above the target i or, A will . In such a case, the Bank might have no intention of  i b but to keep A from becoming excessive it may  i b to keep it more in line with market rates. When i b  the market may interpret this as a signal that the Bank of Canada is moving to a more contractionary policy, even if this is not the case. The announcement effect may be a hindrance rather than a help.

Copyright © 2002 Pearson Education Canada Inc Government Deposit Shifting Prior to the introduction of the LVTS, the management of settlement balances (cash setting) was the main mechanism by which the Bank of Canada implemented monetary policy. In particular, using drawdowns (transfers of government deposits from the direct clearers to the Bank of Canada) and redeposits (transfers of government deposits from the Bank of Canada to the direct clearers), the Bank was essentially implementing its target band for the overnight interest rate. In the LVTS environment, however, the Bank uses twice- daily auctions of government term deposits (the first at 9:15 a.m. and the second at 4:15 p.m.) to effect the shifting of government funds and neutralize certain government flows.

Copyright © 2002 Pearson Education Canada Inc … Neutralizing a Net Government Receipt Consider a net government receipt of $100 (i.e., the government’s receipts from the public exceed its payments to the public by $100). To prevent a  in settlement balances and an  in i or, the Bank neutralizes the net government receipt by morning (9:15 a.m.) and afternoon (4:00 p.m.) auctions of government term deposits, as follows: Bank of Canada Assets Liabilities Government Deposits Settlement Balances +100 Direct Clearers Assets Liabilities Settlement Balances +100 Government Deposits +100

Copyright © 2002 Pearson Education Canada Inc … Neutralizing a Net Government Disbursement If there were a net government disbursement of $100 (i.e., the government's payments to the public exceed its receipts from the public by $100), then settlement balances would  by the same amount. To prevent a  in i or, the Bank neutralizes the net government disbursement by a transfer of $100 from the government's accounts at the LVTS participants to the government's account at the Bank: Bank of Canada Assets Liabilities Government Deposits Settlement Balances -100 Direct Clearers Assets Liabilities Settlement Balances -100 Government Deposits -100

Copyright © 2002 Pearson Education Canada Inc Swaps With the Exchange Fund Account (EFA) The Bank usually brings onto its balance sheet EFA assets to back its liabilities. It does so, by arranging a swap with the EFA. If the Bank temporarily buys $100 of FX from the EFA, then: Bank of Canada Assets Liabilities Foreign exchange +100Government Deposits Government of Canada Assets Liabilities EFA -100 Deposits at the Bank +100 Government deposits at the Bank  and now can be transferred to banks to  settlement balances.

Copyright © 2002 Pearson Education Canada Inc An Example of Monetary Control Suppose that the operating band is 4.5% to 5% and the Bank wishes to tighten policy by raising the band by 25 basis points In one of the eight fixed days for announcing changes to the band for i or, the Bank announces, at 9:00 a.m., that it is adjusting the band up from 4.5% to 5% to 4.75% to 5.25% From this announcement, LVTS participants know that the i b shifts from 5% to 5.25%, the rate on positive settlement balances shifts from 4.5% to 4.75%, and that the Bank’s new target i or, the midpoint of the operating band, shifts from 4.75% to 5% If later in the day overnight funds are trading below the target i or, the Bank enters into SRAs to enforce the new target for i or

Copyright © 2002 Pearson Education Canada Inc An Example of Monetary Control (continued) Assuming that the Bank enters into SRAs in the amount of $100, the T-accounts of the Bank and the direct clearers will be: Bank of Canada Assets Liabilities Settlement Balances -100 SRAs +100 Direct Clearers Assets Liabilities Settlement Balances -100 SRAs +100

Copyright © 2002 Pearson Education Canada Inc An Example of Monetary Control (continued) Because settlement balances  the Bank neutralizes the effect on settlement balances of its issue of SRAs, by auctioning off $100 of government deposits : Bank of Canada Assets Liabilities Settlement Balances +100 Government Deposits -100 Direct Clearers Assets Liabilities Settlement Balances +100 Government Deposits +100

Copyright © 2002 Pearson Education Canada Inc An Example of Monetary Control (continued) The end-of-day effect on the balance sheets of the Bank and the direct clearers is as follows: Bank of Canada Assets Liabilities SRAs +100 Government Deposits -100 Direct Clearers Assets Liabilities SRAs +100 Government Deposits +100 The Bank’s monetary tightening has been effected through the management of settlement balances, during the course of the day, with no change in the aggregate settlement balances