Title: Focus shifts to central bankers
Sub-title: Most Canadians know little about how the Bank of Canada operates. But as credit crunch spin-off effects worsen, maybe they should.
In recent weeks, central bank efforts to stabilize financial markets in the wake of the U.S. real estate sector implosion have increasingly made headlines. The American government and the U.S. Federal Reserve are pumping hundreds of billions of dollars into the economy. In early October, the Fed, the Bank of Canada and several European monetary authorities organized what amounts to the first coordinated global policy interest rate cut since the post-911 days.
Here in Canada the central bank also launched new measures to boost liquidity. While the jury is still out on how well these efforts will succeed, the moves brought to center stage a group of quiet bureaucrats, who wield enormous influence.
Yet despite the effect of central bank actions on world economies, surprisingly few Canadians have more than a fleeting idea of how they operate. Part of the reason for this, is that Canadians continue to have great confidence in their banking system and its regulators. And they may have a point. According to a recently released report sponsored by the World Economic Forum, Canada ranks first among 134 rated nations in terms of the quality of its banking system.
That said, given the Bank of Canada’s increasing presence in highly volatile financial markets, it pays to take a closer look at how the organization works and what its mandate is.
Throw those economics textbooks out the window
These days the first thing those who want to learn about how central banks operate need to do is to throw their old economics textbooks out the window. Standard definitions of the roles of monetary authorities include maintenance of national currency and money supply stability, controlling interest rate policy and acting as a lender of last resort to the banking sector. However turmoil in the financial system has spread so deep that none of the world’s central banks can do any of those things on their own any more.
Financial markets have become so constricted that when central banks cut their policy rates, they have increasingly less effect on bank lending practices. As for acting as “lender of last resort,” to the banking system, in recent weeks, -- as banks become increasingly reluctant to lend to one another,-- the role of central banks is evolving to acting as “lender of first resort.”
For example this week the Bank of Canada announced that it would an additional $8 billion worth of liquidity in the financial system, to top off the $34 billion that it already put in earlier this year and the $75 billion worth of Treasury bills and bonds that it will issue to help the Canada Mortgage Housing Corporation to buy up federally insured mortgage backed securities. These measures would have been unthinkable just a few years ago.
The international context
Yet despite the strength of Canada’s financial system and the high regard in which central bankers here are held, the recent crisis has dramatically highlighted the limits of their influence. Quietly and steadily the global economy has become so interconnected, that no one central bank can achieve its own goals in isolation.
For example few forecasters raised the spectre that any slump in the U.S. housing industry would have repercussions in the Canadian economy beyond a small hit to exporters who would suffer from shrinking demand south of the border. However when U.S. financial institutions began to freeze up their lending, the effects spilled here immediately. U.S. corporate head offices, starved for cash, struggled to find any way they could, to get that financing from Canadian sources including their subsidiaries here as well as from domestic financial markets.
Similarly, when the U.S. Federal Reserve began to slash its policy rate, the spin-off effects were felt here too. As investors moved funds into Canada to take advantage of the increased payouts, the loonie quickly gained in value.
Still some ammunition left
However although central bank’s power to act on their own has declined somewhat, the extent of that decline may be somewhat overstated says one economist. “We repeatedly hear the same fallacies about monetary policy that could cloud investors judgement about the road ahead,” wrote Avery Shenfeld, an economist at CIBC World Markets, in a recent note to the bank’s clients.
One worry is that central banks may have spent their bullets by cutting interest rates too quickly, leaving them no room to maneuver later on. “Not at all,” writes Shenfeld. “A rate cut today is still helping to raise the level of economic activity four quarters from now.” Furthermore argues Shenfeld, central banks can still act even after short-term rates have been cut to zero; all they have to do is to buy longer-dated securities, a move that would cut long-term interest rates as well.
Peter Diekmeyer (peter@peterdiekmeyer.com) is a Montreal based freelance business writer.
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