The Bank of Canada needs to take into account prevailing interest rate environments and adjust its monetary policy tools accordingly, finds a new report from the C.D. Howe Institute. In Lessons from the Yield Curve: Evaluating Monetary Policy in Different Interest Rate Environments
, authors Thorsten Koeppl and Jeremy Kronick explain that it is vital that central banks have a clear understanding on how the impact of monetary policy on the economy, the so-called transmission mechanism, changes based on the underlying interest rate environment.
"Our results suggest that the interest rate environment, whether rates are low or more normal, matters for the effectiveness of monetary policy," notes Koeppl. "Right now, the Bank is stamping out inflation fires, but it should look forward to a new normal in the medium-term, which has implications for what works best in achieving its 2 percent target."
What works, when? The authors answer the question with a novel approach to identifying the effects of monetary policy shocks on the entire yield curve – one that takes into consideration the impact of both unconventional monetary policy, like quantitative easing and forward guidance, as well as conventional monetary policy focused on the Bank's primary policy tool, the overnight rate. Both normal and low interest rate environments were studied.
Their findings are as follows:
- The impact of monetary policy on the economy differs across different interest rate environments;
- Four factors all play a distinct role in how monetary policy effectiveness changes: monetary aggregates, real economy, asset markets, and changes in credit intermediation (lending);
- The credit, asset, and real economy channels play a more significant role in the low interest rate environment and the monetary channel plays a more significant role during normal interest rate periods;
- Evidence suggests that unconventional monetary policy can be successfully used to create additional stimulus at the lower bound of the overnight rate, if needed; and
- A more comprehensive approach to the evaluation of the impact of monetary policy on the economy is more advantageous than traditional measurements.
"As today's interest rates have increased sharply, the impact of monetary policy on the economy will differ in this environment relative to the decade after the financial crisis where interest rates were persistently near the lower bound," says Kronick. "Money conditions, whether cash, bank deposits, or the broader supply of money, may play a more important role in the world we face today. The Bank must adjust its models, putting more weight on some variables, like monetary conditions, and less on others, in order to better gauge monetary policy's likely impact on inflation."
is Fellow-in-Residence, C.D. Howe Institute, and a Professor and RBC Fellow in the Department of Economics at Queen's University.
is Director, Monetary and Financial Services Research, at the C.D. Howe Institute.