Institut C.D. HOWE Institute commentary NO. 429 Securing Monetary and Financial Stability: Why Canada Needs a Macroprudential Policy Framework A newly created Macroprudential Policy Framework with clear objectives, tools and lines of responsibility could offer greater assurance of financial stability, while leaving the Bank of Canada to focus primarily on inflation and output stabilization. Paul Jenkins and David Longworth The Institute’s Commitment to Quality About The C.D. Howe Institute publications undergo rigorous external review Authors by academics and independent experts drawn from the public and private sectors. Paul Jenkins is a former Senior Deputy The Institute’s peer review process ensures the quality, integrity and Governor at the Bank objectivity of its policy research. The Institute will not publish any of Canada. He is a Senior study that, in its view, fails to meet the standards of the review process. Distinguished Fellow at The Institute requires that its authors publicly disclose any actual or Carleton University, a potential conflicts of interest of which they are aware. CIGI Distinguished Fellow; and Senior Fellow In its mission to educate and foster debate on essential public policy at the C.D. Howe Institute. issues, the C.D. Howe Institute provides nonpartisan policy advice to interested parties on a non-exclusive basis. The Institute will not David Longworth endorse any political party, elected official, candidate for elected office, is a former Deputy Governor of the Bank of Canada. He is or interest group. Adjunct Research Professor, Carleton University; Associate As a registered Canadian charity, the C.D. Howe Institute as a matter Director, Risk Policy and of course accepts donations from individuals, private and public Regulation Diploma Program, organizations, charitable foundations and others, by way of general Queen’s University; and project support. The Institute will not accept any donation that and Research Fellow, stipulates a predetermined result or policy stance or otherwise inhibits C.D. Howe Institute. its independence, or that of its staff and authors, in pursuing scholarly activities or disseminating research results. HOW .D E I Commentary No. 429 C N T S U T I T June 2015 T I U T S Monetary Policy T E N I E s e s s u e q n i t t i i l a o l p Finn Poschmann P s ol le i r cy u I s n es Vice-President, Policy Analysis tel bl lig nsa ence spe | Conseils indi $12.00 isbn 978-0-88806-951-1 issn 0824-8001 (print); issn 1703-0765 (online) The Study In Brief Canada’s inflation-target agreement between the government and the Bank of Canada is up for renewal by 31 December 2016. In the aftermath of the 2008-2009 global financial crisis, one of the critical issues for consideration is the integration of price and financial stability in the conduct of policy. ThisCommentary addresses the importance for the conduct of monetary policy of having a separate coherent framework for macroprudential policy – designed to prevent the build-up of systemic, or system-wide, financial risks. A key lesson of the financial crisis was the insufficient attention being paid to these risks and their consequences for the economy. The importance of this issue can be seen in two ways. The first relates to the interactions between monetary and macroprudential policy tools in light of concerns about rising levels of household debt. At various times, there will be situations when only one policy tool is needed, when both policies need to be used in the same direction, or when the two policies need to work in opposite directions. The second relates to the Bank’s current “risk management approach” to monetary policy. In the absence of a government framework for the active use of macroprudential tools, this approach implies that monetary policy becomes a more important line of defence against systemic risks than it needs to be, with the risk of sub-optimal monetary policy outcomes. Our conclusions are threefold: • Canada’s 2 percent inflation target and policy framework has served the economy well, most importantly in anchoring inflation expectations; • over the past two years, Canadian monetary policy would have been better placed to combat low inflation and excess capacity had macroprudential policies been openly geared to reducing the systemic risks associated with rising household indebtedness and housing prices; and • drawing on best practices, the government needs to elevate macroprudential policies by establishing clear objectives, tools and lines of responsibility and accountability. The payoff for Canadians cannot be overstated: greater assurance of both financial stability, as a result of assigned responsibility for macroprudential policy, and monetary stability, as a result of the Bank of Canada’s continued primary focus on inflation and output stabilization. C.D. Howe Institute Commentary© is a periodic analysis of, and commentary on, current public policy issues. Barry Norris and James Fleming edited the manuscript; Yang Zhao prepared it for publication. As with all Institute publications, the views expressed here are those of the authors and do not necessarily reflect the opinions of the Institute’s members or Board of Directors. Quotation with appropriate credit is permissible. To order this publication please contact: the C.D. Howe Institute, 67 Yonge St., Suite 300, Toronto, Ontario M5E 1J8. The full text of this publication is also available on the Institute’s website at www.cdhowe.org. 2 The integration of financial stability considerations into the conduct of monetary policy has become an important issue in all countries. In Canada, how best to integrate price stability and financial stability is one of the central issues the Bank of Canada has identified in the lead-up to the 2016 renewal of the inflation-target agreement with the federal government (Côté 2014). Inflation targeting was introduced in Canada in borrowers and financial institutions; (ii) regulatory 1991. After nearly 20 years of high and variable oversight of financial institutions; and (iii) inflation, with the Consumer Price Index (CPI) macroprudential policy. rising at an annual average rate of over 7 percent, This Commentary addresses why it is important the government and the Bank of Canada jointly for the conduct of monetary policy to have announced an explicit target path for reducing a complementary, coherent framework for inflation to levels considered to be consistent with macroprudential policy. We address two aspects overall price stability. Since then, Canada has had of this issue that have immediate and practical an explicit inflation target that has been extended implications for Canadian monetary policy. The first or renewed five times (Appendix A provides a brief relates to the interactions and spillover effects of history of the inflation-target renewal process).1 monetary and macroprudential policy. At the time of the 2011 renewal, the Bank of Depending on economic and financial Canada, as it did in 2006, recognized the need for conditions, there will be situations when only one flexibility in the conduct of monetary policy to policy tool is needed, when both policies need to play a role in support of financial stability. This be used in the same direction or when the two flexibility has been expressed in terms of the polices work in opposite directions. This means period over which the inflation target is achieved, policymakers need to understand not just the use of potentially involving a longer period to support each policy, but also what guides its use. Moreover, financial stability objectives. Nonetheless, monetary much of the impact of policies works through policy is seen as “the fourth line of defence” (Poloz expectations, which are heavily influenced by the 2014, 7) behind (i) the behaviour of individual guiding frameworks. The authors ouldw like to thank Finn Poschmann and Bill Robson at the C.D. Howe Institute, John Murray, Gordon Thiessen and several anonymous reviewers for their comments on earlier drafts of this Commentary. Any remaining errors remain the authors’ responsibility. 1 One of the distinguishing features of the renewal process has been the consistency in agreement to keep the target at an annual rate of increase in the CPI of 2 percent. Over the period from December 1995 to December 2014, annual CPI inflation averaged 1.9 percent. 3 Commentary 429 The second issue relates to the Bank of Canada’s to deal with these risks and promote financial current risk-management approach to monetary stability. policy (Poloz 2014, 2015). This approach implies Macroprudential policy can address both the that, as in the past couple of years, when active time dimension and the cross-sectional dimension macroprudential policy is little used and when there of systemic risk (CGFS 2010), both of which is no guiding framework, monetary policy becomes were present in the run-up to the financial crisis. a more immediate line of defence against systemic The time dimension of systemic risk refers to the financial risks than it needs to be, with exposure to buildup of risks associated with the financial cycle greater risk of suboptimal outcomes in missing the or credit cycle. In the run-up to the global financial inflation target and compromising monetary stability. crisis, these risks related to the rapid growth in Our conclusions are threefold: many countries of total credit, residential mortgage • Canada’s 2 percent inflation target and policy credit, especially US subprime mortgage credit, and framework have served the economy well, most house prices in real terms (that is, relative to the importantly in anchoring inflation expectations; general level of prices). Rapid credit growth was • over the past two years, Canadian monetary associated with a significant rise in the leverage of policy would have been better placed to banks in many countries, as their assets rose relative combat low inflation and excess capacity to capital.