The Bank of Canada building in Ottawa on May 16, 2019.Sean Kilpatrick/The Canadian Press
A growing number of Bay Street analysts are betting that the Bank of Canada will stop shrinking its balance sheet and resume buying bonds in the coming months, potentially capping a multi-year experiment earlier than expected and kicking off a new phase for monetary policy.
The central bank has been slimming down its balance sheet over the past two years, after a period during the pandemic when both its assets and liabilities ballooned.
This process, known as quantitative tightening, or QT, involves the Bank of Canada letting the huge sums of government bonds it bought in 2020 and 2021 mature without replacing them. This has the effect of draining money out of the financial system, reinforcing the restrictively high interest rates the bank is using to slow the economy and combat inflation.
QT has been working quietly in the background since the spring of 2022. Bank officials said last year they expected it to end sometime in late 2024 or early 2025, at which point the bank would start buying bonds again to stabilize its balance sheet. But there are signs, emanating from the heart of the financial system, that the bank may need to shift gear sooner rather than later.
In recent months, interest rates in key short-term lending markets have been hovering above the central bank’s target, suggesting demand for cash may be exceeding supply, at least in some corners of the money market. That prompted several market interventions by the bank in January – the first such maneuvers since before the pandemic – and generated private-sector speculation that QT is getting long in the tooth.
To a large degree, the end of QT is a technical matter with limited bearing on the key economic question of the day: When will the Bank of Canada start cutting interest rates?
“We see it as much more of a financial plumbing issue,” Simon Deeley, director of Canada rates strategy at Royal Bank of Canada, said in an e-mail. Decisions about when to cut interest rates, by contrast, are tied to macroeconomic questions about the pace of inflation and economic growth, he said.
Still, the Bank of Canada’s decisions around when and how to wind down QT will impact bond markets and could ripple through the broader economy, analysts say. And these choices will determine the new steady state for Canada’s financial system after several years of extraordinary change, during which the bank experimented with unconventional tools and shifted to a new system for conducting monetary policy.
These are the later stages of a process that began in the spring of 2020 when COVID-19 plunged the world economy into crisis. The Bank of Canada cut interest rates to near-zero to stimulate lending and borrowing. It also began buying huge sums of Government of Canada bonds, first to prevent financial markets from seizing up, then later as a form of monetary policy aimed at boosting economic activity.
This process, called quantitative easing, or QE, looked to bid up the price of longer-dated benchmark bonds to lower their interest rates at a time when the bank’s main monetary policy tool, its policy interest rate, couldn’t go any lower. (Bond prices and yields move in opposite directions.)
At the program’s height, the bank was buying $5-billion worth of federal bonds from investors every week, and its holdings grew from roughly $80-billion to a peak of nearly $440-billion in late 2021.
The bank paid for these assets by creating settlement balances, a type of electronic money that commercial banks hold at the central bank and use to settle transactions with one another, similar to reserves in the U.S. Federal Reserve system. Because the central bank is the ultimate source of liquidity in the financial system, it can add electronic money to commercial bank accounts with a keystroke – pumping cash into the banking system in exchange for longer-dated assets.
Quantitative easing wasn’t new in the world of central banking. The Bank of Japan pioneered large-scale asset purchases in the early 2000s, and the U.S. Federal Reserve, European Central Bank and Bank of England all used QE during or after the 2008 financial crisis. But it was a first for the Bank of Canada, which had previously avoided the more radical forms of unconventional monetary policy.
The bank ended QE in the fall of 2021 – its first step toward tightening monetary policy in response to rising inflation. The following spring it shifted into reverse and began QT, the long process of shrinking its balance sheet as a complement to interest rate hikes.
Under QT, the bank hasn’t been outright selling the bonds it owns. But it has been letting them mature without replacing them. Its Government of Canada bond holdings have declined to around $260-billion.
As these bonds mature, the bank is simultaneously destroying the electronic money – settlement balances – that it created to purchase the bonds in the first place. Since 2021, settlement balances have shrunk from $400-billion to slightly more than $100-billion.
The key question now is how many settlement balances the Bank of Canada wants to leave in the financial system going forward.
Bank of Canada deputy governor Toni Gravelle said in a speech last year that he expected to end QT when settlement balances had fallen to between $20-billion and $60-billion, likely in late 2024 or early 2025. At that point the bank would begin buying bonds again – not to expand its balance sheet, but to hold its assets and liabilities steady.
But Mr. Gravelle said this estimate for settlement balances was highly uncertain. The bank, he said, would be monitoring repo markets, where financial institutions lend and borrow money overnight against high-quality collateral, for signs that demand for cash in the banking system was exceeding supply.
“If we were to see persistent upward pressure on the overnight repo rates in the market before settlement balances reached our estimate of the steady-state level, it could very well mean our estimate for the range was too low,” Mr. Gravelle said.
This exact thing has been happening in recent months.
The Canadian Overnight Repo Rate Average, or CORRA, which captures the cost of borrowing money overnight in repo markets, is meant to tightly track the Bank of Canada’s policy interest rate. But since the fall it has traded around 5 basis points above target (a basis point is one hundredth of a percentage point). It has moved closer to the target in recent weeks.
That may not seem like a large divergence. It’s certainly less dramatic than what the U.S. Federal Reserve had to deal with in 2019, when repo rates briefly jumped nearly 3 percentage points above the Fed’s target, prompting it to halt its QT efforts.
But when CORRA drifts away from the bank’s target, it impacts how well monetary policy is transmitted into broader financial markets and ultimately along to consumers and businesses. Fundamentally, central banks conduct monetary policy by influencing short-term market interest rates, which provide a benchmark for other types of borrowing in the economy.
“It is a problem, because when you think about the transmission of monetary policy, if your overnight repo rates are too high or too low, then it just reduces the efficacy of your hiking or easing cycle,” said Ian Pollick, head of fixed income strategy at Canadian Imperial Bank of Commerce.
In January, the Bank of Canada intervened directly in repo markets several times, pumping cash into the financial system on a short-term basis to nudge CORRA closer to target. This type of maneuver was commonplace before the pandemic, but had not been used since the start of QE. In February, it reintroduced daily auctions for excess government cash balances – another tool aimed at boosting liquidity in the financial system.
Ultimately, uncertainty about the end of QT is tied to the fact that the Bank of Canada is now operating under a new monetary policy regime, which treats settlement balances very differently than before.
Prior to the pandemic, the Canadian financial system operated with very few reserves at the central bank: roughly $250-million worth of settlement balances at any given time. In this “corridor” system, the Bank of Canada could influence short-term market interest rates by injecting or withdrawing cash from the banking system on a short-term basis.
QE changed this set-up. With so much cash in the financial system, the Bank of Canada no longer influences market rates by altering the quantity of reserves. Instead it pays interest on its drastically increased settlement balances, setting a floor below which market interest rates typically won’t fall. In effect, if a commercial bank can park money overnight at the central bank and earn interest, it will only lend that cash out to other market participants at a higher rate.
“In the corridor system with minimal reserves, the bank needs to constantly engage in overnight operations to balance out any changes in the demand for settlement balances. With ample reserves or with the floor system, the supply is so large that little shocks to demand don’t matter, and the bank doesn’t need to do a thing,” said Trevor Tombe, an economics professor at the University of Calgary.
The key question is how far settlement balances need to fall before commercial bank lending decisions, and interest rates, are once again influenced by the quantity of reserves in the banking system, he said. “That’s a level of settlement balances that we don’t actually know where it exists.”
Few private-sector observers expect the Bank of Canada to offer much guidance on the issue on March 6, the date of its next interest rate announcement. But Mr. Gravelle will be delivering a highly anticipated speech about the central bank’s balance sheet later in the month.
Most analysts think the fate of QT is a separate matter from when the Bank of Canada will start lowering interest rates. But this doesn’t mean that it can’t have a real economic impact. Mr. Pollick said that the amount of settlement balances the central bank decides to leave in the system could impact commercial bank lending activity.
“There’s a real economic consequence that we need to think about, particularly as the demand for cash increases when you go to these massive mortgage refinancings over the next two years,” he said.
Andrew Kelvin, head of Canada and global rates strategy at Toronto-Dominion Bank, said the key question is what assets the Bank of Canada will start buying when it ends QT.
Before the pandemic, it would take a small portion of every federal government bond issuance. But with a large portion of its bond holdings maturing in the coming quarters, it may need to purchase bonds in the secondary market to keep its balance sheet steady.
“I actually think it’s going to be quite a challenging thing for them just operationally to figure out how to start purchasing securities again without distorting the market,” Mr. Kelvin said.