Bank of Canada Govenor Mark CarneyKevin Coombs
The Bank for International Settlements is in the news because of its latest recommendations. What exactly is its function?
The BIS is essentially a club for central bankers - those who set the monetary policy of their countries.
It does research and acts as a forum to discuss central bank issues. It is also a bank used by central bankers to manage their foreign exchange reserves. Sometimes it provides emergency financial assistance to central banks.
One of the key roles of the BIS is to set standards. This is usually done through one of its standing committees, the Basel Committee on Banking Supervision. It issues recommended levels for the amount of capital that commercial banks should hold, for example.
There are now 55 members of the BIS, including Canada.
When and why was it established?
The BIS was initially set up in 1930 to administer the reparations payments that were forced on Germany after the First World War. That's why the word "settlements" is in its name.
Another role was to promote co-operation among central banks, and that quickly became its main function as the worldwide financial crisis of the 1930s spread.
Switzerland was a compromise choice as the location for BIS headquarters, because of its neutrality. Basel was selected as the home base because it had good railway connections.
The original member countries were Belgium, France, Germany, Italy, Japan, Britain and the United States.
What is Basel II?
The Basel II accord is an agreement among BIS members, signed in 2004, that sets minimum capital ratios for banks and governs the way they deal with risk.
Basel II is a modernization of a set of rules in the first Basel accord in 1988. The new rules are only now coming into force in many countries, and critics say the recent worldwide financial crisis shows they are already out of date.
With all the "pump-priming" from central banks (particularly the U.S. Fed), what are the dangers of inflation rising sharply in the future?
There is very little risk that inflation will jump in the short term, as the global economy is still very slow.
But the increase in the money supply prompted by central banks' purchase of financial assets, particularly in the United States, could be a danger when the economy rebounds.
TD Bank economist James Marple said the key issue is how the Fed times its attempts to reduce the money supply as the recovery starts to take hold. In the past, the Fed mainly owned government securities, which were easy to dispose of. But it now also holds private assets, such as commercial paper and loans to financial institutions, and these will be harder to sell in a hurry if inflation starts to ramp up.
What is a liquidity injection ?
Central banks can use their financial clout to try to get money flowing to the commercial banks and their customers. In a liquidity injection, they make money available for banks to borrow, although the financial institutions have to post securities as collateral to get it. Last week the Bank of Canada said it would make $20-billion available to Canadian banks, and yesterday it said it would let banks pledge their troubled asset-backed commercial paper assets as collateral. This will give some banks - at least those with large pools of ABCP - more flexibility.
One problem, said TD Bank chief economist Don Drummond, is that the central bank's liquidity injection is just for the short term - Bank of Canada loans usually have to be repaid within 90 days. But the demand from customers is trending toward longer-term loans - especially from corporations that can't get money any other way - so the central bank money won't help much on that score.
Where do the central banks get the money for a liquidity injection ?
The Bank of Canada has billions of dollars in assets - about $56-billion, at last count - mostly held in very safe securities such as bonds and treasury bills. In essence, when it makes money available to commercial banks, it is temporarily swapping its safe securities for the riskier ones the banks are putting up as collateral.
Why have central banks been unable to halt the credit crisis ?
The Bank of Canada continued its efforts to add some grease to the financial system, but there was no sign of any change for the better. In the United States, pressure has been building on the Federal Reserve to push through an emergency interest rate cut to bolster confidence. There has been talk that other countries would similarly cut rates.
What was behind the Federal Reserve's plan to buy up commercial paper ?
The central bank is stepping in as a buyer of last resort in the $1.6-trillion (U.S.) market for commercial paper. This is a form of short-term debt that thousands of companies use to finance their daily operations, including paying employees and buying supplies. The Fed hopes to kick-start this market and free up funds for corporations. The central bank said it was taking the action because money market mutual funds and other investors were loathe to buy commercial paper.
Ian Stannard, a currency strategist at BNP Paribas in London, described the move as "probably the first piece of news we've had that starts to address the underlying problem in the financial system. This is a very pro-active step and will be a huge help to getting things moving again."
How effective will the Fed's new measure be ?
The historic move should unclog the market for these business IOUs, helping to insulate the real economy from the credit crunch. The hope is that, over time, private investors will feel confident enough to return to the market, allowing the Fed to withdraw. The catch is that the commercial paper market is just one piece of a massive and interconnected credit system that is no longer functioning, and the Fed can't possibly nationalize it all. Douglas Porter, deputy chief economist at BMO Nesbitt Burns, said the central bank is putting itself even more into the "credit creation process" and taking on more risk as a result.
Will it work? "This welcome step should alleviate some of the pressure on companies which were finding even day-to-day operations difficult to manage. … Still, the problems besetting the credit markets are so multi-dimensional that no move will be a single fix," Mr. Porter said, noting the Fed wants to use every measure possible before cutting its benchmark Federal funds rate.
How is the Bank of Canada different from the U.S. Federal Reserve ?
All major central banks share a mission as lender of last resort. They also seek to set the tone for the economy by raising or lowering benchmark lending rates. It's how they perform this latter function that differentiates them. The Bank of Canada, like most major central banks, has a legislated mandate to keep a lid on inflation. In the Bank of Canada's case, the mandate is to keep prices advancing about 2 per cent a year. The Governor, advised by five deputies on the Governing Council, sets the Bank of Canada's overnight target for loans between banks at whatever level he deems necessary to achieve that goal.
The Fed has a slightly different mission. While it is charged with containing inflation, the Federal Open Market Committee also sets borrowing costs to promote full employment, economic growth and a sustainable pattern of international trade. The FOMC, the Fed's equivalent of Canada's Governing Council, also is a larger body, consisting of the Fed chairman, the six other members of the Board of Governors and five of the presidents of the Fed's network of regional banks.
Is it possible for a central bank, such as the U.S. Federal Reserve Board, to set its key lending rate at zero per cent? Has this ever happened ?
Japan's benchmark interest rate was at zero per cent from 2001 to 2006, as its central bank tried to encourage economic growth. But it didn't work very well and the Japanese economy stayed in the doldrums.
If the U.S. benchmark rate, now at 1 per cent, were to be dropped to zero it would not apply to all borrowing, but just to some interbank lending. Other rates would likely be very low, however, making borrowing cheap for individuals and companies - at least those that could get credit.
One problem is that once the rate is at zero, the Fed would have no room to manoeuvre. Often it is the act of dropping rates, rather than the absolute value of the rate, that spurs the economy.
At zero, there's nowhere to go but up.
What is the difference between the U.S. Federal Reserve Board and the Department of the Treasury ?
The Federal Reserve Board, often called the Fed, is the central bank of the United States. It has a similar role to the Bank of Canada, in that it sets interest rates and lends money to member banks.
It also regulates banks, a job that in Canada is performed mainly by the Office of the Superintendent of Financial Institutions. The Fed also manages the United States' cheque clearing system.
The Department of the Treasury is the arm of government that manages finances, much like Canada's Finance Department.
It collects taxes (a role performed in Canada by the Canada Revenue Agency), pays government bills and manages federal government debt. The Treasury also prints paper currency and mints coins.
Why is the U.S. Fed's key interest rate (at 1 per cent) different from the Bank of Canada's key rate (2.25 per cent), yet the prime rate in both countries is the same (at 4 per cent) ?
In recent years, Canadian banks have been setting their prime rate 175 basis points above the Bank of Canada's overnight target rate. (A basis point is 1/100th of a percentage point.) The U.S. banks have tended to set prime 300 basis points above the Fed funds rate.
U.S. prime is set at a larger spread because not many borrowers there actually borrow at prime. Most businesses borrow at rates tied to Libor - the London interbank offered rate. Those that do borrow at prime often are considered a slightly higher risk, so the spread is bigger.
It is just a coincidence that the Bank of Canada's key rate, plus the usual spread, now equals the Fed rate plus the usual U.S. spread, making the prime rate the same in both countries.
Has the Bank of Canada ever cut rates as deeply as it did yesterday ?
The last time there was a cut of 75 basis points was in October, 2001, just after the Sept. 11 terrorist attacks. At the time, central banks around the world were slashing rates to try to boost confidence in international markets and economies.
There were several earlier occasions when the central bank's key rate fell by that amount or more - many of them in the 1980s.
Has there ever been an increase of more than 75 basis points ?
Yes, several times from the 1960s to the 1990s.
The most recent big jump was on Aug. 27, 1998, when the Bank of Canada boosted rates by a full percentage point (to 6 per cent). It was trying to stop the freefall of the Canadian dollar, which was trading at just over 63 cents (U.S.). At that time commodity prices were at two-decade lows, putting pressure on Canadian resource industries.
Six years earlier the central bank had taken its most drastic action ever, boosting rates by 193 basis points on Oct. 1, 1992. The idea then was to prop up the dollar because of concerns over possible fallout from the upcoming national referendum on the Charlottetown constitutional accord.
That was the biggest rate change since the Bank of Canada was created in 1935.
What is the lowest Canadian interest rates have ever been ?
From 1944 to 1950, the Bank of Canada's key rate (which was set differently at the time) was at 1.5 per cent. It dropped briefly to that level in 1955 and then went slightly below for a short period in the summer of 1958, but didn't hit that mark again until yesterday.
Does "quantitative easing" really involve the central bank printing money ?
Quantitative easing is the process where a country's central bank pumps money into the financial system by buying up government debt, mortgages, commercial loans or stocks. With interest rates near zero, some central banks are turning to this strategy to try to get retail lending rates down further. While they likely won't physically print more money, central banks do effectively create more money when they engage in this process, by crediting the accounts of the financial institutions they are buying assets from.
Has the Bank of Canada done this yet ?
No. Up to now the bank has just been lending to financial institutions, and getting other assets in return as collateral.
Our central bank also has a little more room left to boost the economy by lowering interest rates. Today, it is expected to lower rates by half a percentage point to 0.5 per cent. After that, however, it might have to resort to quantitative easing to spur economic growth.
The U.S. Federal Reserve Board has begun quantitative easing, and the Bank of England has said it will consider the technique.
The Bank of England is expected to start buying corporate and government bonds from some banks, by crediting the banks' accounts, as early as this week.
What is the downside to central banks essentially creating money through "quantitative easing" ?
The main risk of quantitative easing - where a central bank pumps money into the financial system by buying up government debt, mortgages, commercial loans or stocks - is that it can ignite inflation.
BMO Nesbitt Burns deputy chief economist Douglas Porter points out inflation is not a serious risk in today's environment. However, those setting economic policy don't want to do anything that might recreate the nightmare scenario of the 1970s, where many economies were weak and inflation was rising at the same time.
Consequently, central banks such as the Bank of Canada will likely take cautious steps in moving to quantitative easing, he said.
Even the Bank of Japan, which pretty much started the trend when its interest rates hit zero in the 1990s, was careful in pumping new money into its economy because of concerns over inflation.
There seems to be divergent views on whether the stimulus money that central banks plan to pump into the economy through "quantitative easing" will cause inflation. Why the disparity in viewpoints?
Central banks, including the Bank of Canada, have argued that there is very little risk of inflation right now, so there is room to pump money into the economy - normally an action that would boost inflation.
In fact, there are worries of deflation - dropping prices that could cause a weakening economy to get even worse.
The key question is, what will happen when the economy turns around? At that point inflation could become an important factor. Central banks would likely try to fight it by removing the money they have created. Essentially, they would sell off the assets that they bought - the government debt, mortgages, commercial loans or stocks.
Is that easy to do?
The hard part is getting the timing right. Taking the money out too soon could abort a rebound. A deputy governor of the Bank of England said recently that reversing the stimulus is "easily accomplished," but not everyone thinks the central banks will figure out how to do this at the right time.
Does the Bank of Canada keep track of its forecasts for future growth, to see if the past predictions were accurate?
No, the central bank doesn't evaluate its past forecasts, although its regular "monetary policy reports" remain on its website so anyone can look back and see if they were close to the mark.
The reports are published each April and October, with updates in July and January.
The idea is that the forecasts are updated as new information becomes available, and as the bank's governing council changes its views. Essentially, they evolve as economic conditions change, so past forecasts often become outdated.
But you can go back and see how accurate they have been at any point in time. A little over a year ago, for example, the bank said it expected economic growth of 2.8 per cent for Canada in 2009, a forecast that in retrospect seems wildly optimistic, but reflected the environment at that time.