E Canada Has Negative “Real” Central Bank Interest Rates? Are Interest Rates Too Low?

“I have talked before about the process of bringing the economy back home—at the intersection of full capacity and 2 per cent inflation. Our return home was made even longer by the detour we took when oil prices collapsed back in 2014. But, today, we find ourselves quite close to home, and getting closer, with the economy now running close to full output and inflation expected to be around 2 per cent later in 2018” (Bank of Canada Governor Poloz, Press Conference, Dec. 14, 2017)

In its 2017-year-end publication (“Top charts to think about going into 2018”), National Bank of Canada economists highlighted their concern that Canada’s central bank interest rates were too low.

The crux of their argument relied on the fact that Canada’s economy had an unusually strong growth spurt in 2017. The national unemployment rate fell sharply in 2017, money wages increased on a y/y basis and inflation started to accelerate. Moreover, the Bank of Canada output measures suggest that the Canadian economy was operating close to or slightly above full capacity.

In other words, does the Canadian economy still require a negative real overnight interest rate, (i.e. the overnight policy rate minus the rate of inflation)?

The BoC overnight target rate is currently 1.25%, while in November core inflation was estimated to be somewhere between 1.5% and 2%. The actual increases in the consumer price index in November was 2.1% y/y.

A negative central bank interest rate (NIRP) is an unconventional monetary policy tool whereby nominal target interest rates are lower than the rate of inflation. Negative interest rates are intended to provide banks with incentives to lend money more freely and businesses and individuals to invest, borrow, and spend their funds rather than pay a fee to keep it safe.

Negative real interest rates play a key role in government fiscal policy as well as in monetary policy. Since 2010, for example, the U.S. Treasury has been borrowing funds at negative real interest rates on much of its government debt, which in effect reduces the pain of deficit financing.