(Bloomberg) -- The Bank of Canada said the threshold for using special monetary policy tools such as quantitative easing and very forward guidance “should remain very high” after reviewing its response to the Covid-19 pandemic to see how to deal with future crises. ".
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In a series of documents released on Friday, the central bank launched a broad review of how it handled the economic shock from the novel coronavirus in early 2020. The report comes as US President-elect Donald Trump threatens to impose tariffs that could collapse the US economy. If enacted, Canada would be plunged into recession.
"The Bank recognizes that these special monetary policy tools should remain special and be used only during periods of extreme economic stress," it said in the document.
In March 2020, the central bank lowered the key policy interest rate from 1.75% to 0.25% and launched a series of liquidity facilities and asset purchase plans.
Friday's report examined the bank's use of quantitative easing, or large-scale government bond purchases, during the pandemic. It acknowledges so-called moral hazard – the idea that market participants may take greater risks if central banks intervene. To prevent such an outcome, the bank said it would "make it clear that it will be undertaken in limited circumstances".
Going forward, it said it also recognized the need to distinguish between large-scale asset purchases designed to support market functioning and asset purchases designed to put downward pressure on yields. The company said the former was deployed early in the pandemic and the latter starting in July 2020.
"If the bank needs to deploy such operations in the future, the bank will be more specific in distinguishing the difference between asset purchases to restore market functions and currency-stimulated asset purchases," the bank said.
Quantitative easing increased the country's gross domestic product by 0.2% to 3% at its peak, the bank said, citing multiple studies. Emergency bond purchases led to inflation rising by 0.1 to 1.8 percentage points, although the bank said this estimate "may not give an accurate picture".
One of Governor Tiff Macklem's first and most controversial decisions in 2020 was to communicate to Canadians that interest rates would remain low for longer than the market expected. Households are encouraged to make bulk purchases when considering doing so.
In an executive summary of the bank's review, policymakers said one risk of unconventional forward guidance is that "efforts to communicate guidance as simply as possible may cause the market or the public to interpret it as a broader guarantee than expected."
The Bank's Governing Council agreed that the use of special forward guidance should always be "conditional" and specifically linked to the inflation outlook. In 2020, the central bank's pledge to keep interest rates lower for longer depends on the output gap - an abstract theoretical indicator of economic weakness.
"If the central bank does not stick to its word, it could be accused of breaking its promise," the bank said.
In March 2022, as inflation soared, officials began an aggressive series of rate hikes much earlier than McCollum's forward guidance originally suggested.
The central bank now faces another period of significant economic uncertainty. Trump has threatened to impose 25% tariffs on Canadian imports, and Prime Minister Justin Trudeau's government has said it intends to retaliate with escalating tariffs.
On Thursday, Deputy Governor Toni Gravelle said the possibility of rising inflation and economic damage was complicating the central bank's response.
The review also comes amid a rapidly changing political situation. Trudeau plans to resign as his Liberal Party searches for a new leader. Conservative leader Pierre Poliyev, who is leading in opinion polls by a wide margin, criticized the central bank's first-ever quantitative easing policy, saying it fueled inflation. He even threatened to fire McCallum during his 2022 leadership campaign.
Economists Pablo Hernandez de Cos, Christine Forbes and Trevor Twombe reviewed the central bank's report, which they themselves deemed "generally positive." Still, they raised some concerns.
They questioned why the central bank's review did not include a broader discussion of why 0.25% was chosen as the effective lower bound for interest rates, and why officials opted for quantitative easing and forward guidance rather than further cuts.
“Has the central bank discussed whether the floor is changing and whether further reductions in policy rates in response to the outbreak will reduce the use of unconventional tools?” they asked. They also question whether interest rates will move significantly higher in 2022 if central banks provide less stimulus during the crisis.
(More timeline details about the pandemic crisis and recovery have been added throughout the article.)
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