The Bank of Canada’s independence takes another hit

Bank of Canada Governor Tiff Macklem is back in the hot seat after the central bank this week announced a $522-million third-quarter loss, the first such red ink in the institution’s nearly nine-decade history. More losses are expected in the coming months, creating an awkward situation for the federal government and raising inevitable questions about the bank’s independence.

The third-quarter loss is the result of the central bank’s decision to buy hundreds of billions of dollars worth of Government of Canada bonds from chartered banks during the pandemic. The measure – known as quantitative easing – aimed to inject liquidity into the financial system and drive long-term interest rates lower. It worked extremely well for a while, sparing Canada the consequences of what might otherwise have become a deflationary spiral and all-around panic.

QE was an experiment, however, one whose long-term effects are still playing out. The overall success (or failure) of this experiment can only be known in the fullness of time, after all the shoes that the central bank threw into the air in 2020 and 2021 hit the ground.

For months now, Canadians have been experiencing one of the unintended consequences of QE, namely the highest rate of inflation in three decades. While external factors such as global supply-chain bottlenecks and the war in Ukraine were initially to blame for sending prices upward, the QE-induced increase in the money supply created the conditions for inflation to take root. Hence, the central bank’s dramatic course-correction this year, raising its key lending rate six times from 0.25 per cent to 3.75 per cent. Further increases are on the horizon.

Rising interest rates are why even deeper central-bank operating losses are in the offing. The commercial banks have been holding the proceeds from the federal bonds they sold to the Bank of Canada in 2020 and 2021 in interest-bearing accounts at the central bank. (Recall that the central bank created the money to buy these bonds out of thin air.) The hitch is that, while the bonds carry an average coupon rate of less than 1 per cent, the Bank of Canada is now paying 3.75 per cent on chartered bank deposits, known in central-bank lingo as settlement balances.

Last week, Mr. Macklem told MPs to brace for more red ink in coming quarters. “The size and duration of the losses will ultimately depend on a number of factors, including the path of interest rates and the evolution of both the economy and the [central bank’s] balance sheet,” he said, all while stressing: “The losses do not affect our ability to conduct monetary policy.”

Still, the central bank’s red ink is not the mere “accounting issue” that Mr. Macklem would have Canadians believe it is. One way or another, the federal government is responsible for the Bank of Canada’s losses. In 2020, the Department of Finance entered into an indemnity agreement with the central bank that insulates it against any losses stemming from a decline in the market value of the federal bonds it holds on its balance sheet. And the bonds the bank bought in 2020 and 2021 have indeed dropped in value, to the tune of more than $31-billion as of Sept. 30., a function of the inverse relationship between interest rates and bond prices.

For now, that amount consists of unrealized losses, since the bank is holding on to its federal bonds until they mature. But monetary policy experts Steven Ambler, Thorsten Koeppl and Jeremy Kronick warn that there is a risk that the central bank could be seen as deciding whether to hold or sell federal bonds based on the government’s preferences. “If the bank were to sell these assets before they mature, this indemnity agreement adds to the operating expenses on the Government of Canada’s statement of operations, possibly triggering an extra need for the government to issue more debt,” the authors note in a recent C.D. Howe Institute study. “The government might have an incentive to prefer the bank’s hold-to-maturity strategy.”

Mr. Macklem and Liberal Finance Minister Chrystia Freeland have gone to great lengths to insist that the central bank remains wholly independent from the government. Still, the bank has appeared to act in concert with the federal government since the pandemic. There is little doubt it would have done so regardless of which party was in power when COVID-19 struck.

The problem is that there are plenty of politicians who think monetary policy should be a tool for achieving all sorts of unrelated policy objectives, and that the central bank should be an agent of the government. Mr. Macklem has done little to disabuse them of such ideas, engaging the bank in debates beyond its bailiwick in a bid to improve its public image. The bank’s QE-related losses will only make it harder for him to defend the bank’s independence now.