Monday, April 27, 2009

What comes after the ELB?

In its recent policy statement, the Bank of Canada took the unprecedented step of declaring a conditional commitment to keeping the overnight rate at an effective lower bound (ELB) of 25bps until June 2010. Moreover, In its accompanying Monetary Policy Report, the Bank has forecast that inflation will not return to target until the third quarter of 2011. This got me thinking – what do these two statements imply about the Bank’s strategy in moving the overnight rate off of the ELB and to some “neutral” level?

The path of short interest rates that is consistent with 2% inflation by Q3 2011 would be readily available to policymakers from running the Bank’s medium term projection model, ToTEM. I tried to elicit some indication of future policy from Pierre Duguay at a recent presentation but he quite rightly only waved his hands.

Fortunately, we don’t need to extract such information from reticent Bank of Canada Governors when we can employ a Taylor Rule. Plugging the Bank’s most recent forecast for growth and inflation into a simple Taylor Rule provides the following (Click to Enlarge):

The rule suggest that monetary policy consistent with 2% inflation would have interest rates rise 225 basis points between June 2010 and September 2011. It would be interesting to observe if there is any action in bond markets based on the BoC outlook. I'm no expert in the matter but if this analysis is reasonably accurate, there should be money to be made shorting the front end of the government yield curve next summer.


Bank of Montreal said...

June 2010 is way too long for them to keep it at this rate. I'd be a bit afraid of such a step, loosing credibility on such acts or on the fact that they're causing massive inflation, loss of capital, devaluation of money is a big negative. I wouldn't be surprised if one day Central Banks around the globe would go extinct, I'm sure nobody would care a bit.

Take care, Lorne

Shock Minus Control said...

Lorne - It will certainly be interesting to see if the BoC breaks their commitment.

I sure hope you are wrong about Central Banks, if you're right I'd have to learn a whole new set of models.