Chapter 16 Tools of Monetary Policy Part 1

The Economics of Money, Banking, and Financial Markets Chapter 16 Tools of Monetary Policy Learning Objectives (1 of 2) 1. Characterize the framework for the implementation of monetary policy in Canada (the LVTS, the target and the operating band for the overnight interest rate, and the Bank of Canada’s standing liquidity facilities). 2. Illustrate the market for reserves and how changes in monetary policy affect overnight interest rates. 3. Discuss the Bank of Canada’s approach to monetary policy. Learning Objectives (2 of 2) 4. Summarize how conventional monetary policy tools are implemented and the strength and weaknesses of each tool. 5. Explain the key monetary policy tools that are used when conventional policy is no longer effective. 6. Identify the distinctions and similarities between the monetary policy tools of the Bank of Canada and those of the Federal Reserve and the European Central Bank. The Large Value Transfer System (LVTS) • The Large Value Transfer System (LVTS) – Operated by Payments Canada • The LVTS participants know the balance of their large-value (over $50,000) transactions in real time • LVTS transactions account for < 1% of the total number of transactions, but 87% of the value • Settlement at the end of each day – The LVTS uses multilateral netting. Only the net credit or debit position of each participant vis-à-vis all other participants is calculated for settlement Systemic Risk and the LVTS • The possible inability of one financial institution to fulfill its payment obligations poses a risk to the entire payments system • The setup of the LVTS helps eliminate this source of systemic risk • Participants can make a payment only if: – they have positive settlement balances in their accounts with the Bank of Canada, – posted collateral (such as T-bills and bonds), or – explicit lines of credit with other LVTS participants Non-LVTS (ACSS) Transactions • These are non-LVTS (paper-based) payment items, such as cheques • These items are cleared through the Automated Clearing Settlement System (ACSS), an electronic payments system also operated by the Payments Canada • The ACSS aggregates interbank payments and calculates the net amounts to be transferred from and to each participant’s settlement account with the Bank of Canada • The Direct Clearers are subset of LVTS participants who participate directly in the ACSS The Bank of Canada’s Policy Rate • Let’s turn to the overnight interbank market, the interbank market for funds with a maturity of 1 day • Overnight interest rate or the Reference rate – The interest rate at which banks borrow and lend overnight funds to each other in the interbank market • The policy rate – The target for the overnight rate that is announced by the BoC - the main target the BoC adopts when conducting monetary policy The Operating Band for the Overnight Rate • The Bank’s objective is to keep the overnight rate within a band of 50 basis points (1/2 of 1%) • There are exceptions at times: – In response to the global financial crisis, the BoC temporarily narrowed the operating band for the overnight interest rate to 25 basis points (1/4 of 1%) – During the COVID-19 pandemic this happened again – In both cases the BoC moved to a “floor system” • The Bank operates under a system of eight “fixed” dates throughout the year for announcing changes to the operating band The Bank of Canada’s Standing Facilities (1 of 2) • At the end of each banking day, each LVTS participant must bring its settlement balances with the BoC to zero • The Bank of Canada therefore stands ready (with standing liquidity facilities) to lend reserves to bring possible negative settlement balances of a bank to zero – The BoC stands also ready to absorb (borrow) any positive settlement balances of a bank – Yet, as we will see later excess reserves are typically best lent out in the overnight market, and in case of a shortage banks would normally best borrow on the overnight market – Indeed, the overnight interbank market should be seen as the daily market for reserves The Bank of Canada’s Standing Facilities (2 of 2) • More about the standing facilities… • The initiative is on the side of the LVTS participant – Participants may use the BoC’s lending facility to obtain overnight liquidity in case of a shortage, or – Participants may use the deposit facility to make deposits in case of excess liquidity – When deciding participants know the rates applicable to positive & negative settlement balances  The bank rate – 50 bps on the deposit facility  The bank rate on the lending facility