Changing the central bank’s mandate could have ‘dangerous’ consequences: report

The Bank of Canada should stick to its knitting when it comes to monetary policy, according to an upcoming report from the C.D. Howe Institute.

The report, which will be released on Tuesday, studied whether the central bank’s mandate should be expanded to include financial stability — something C.D. Howe said “would bring the institution dangerously close to making political-style decisions.”

Report authors Michael D. Bordo and Pierre L. Siklos wrote that financial stability “requires a much wider set of tools” than those at the disposal of the central bank.

The report argued that the idea of a central bank being able to maintain financial stability is based on mistaken assumptions, including that all financial crises are the same.

The global financial crisis of 2008, the report noted, was driven by excessive credit growth, but it’s “up to the politicians” to curb things like credit growth.

“For example, restrictions on the type and size of mortgage loans, or the make-up of risky versus riskless assets in portfolios, represent decisions not historically associated with monetary policy and central banking, at least in advanced economies,” the report stated.

There is also the mistaken assumption that the size and timing of financial crises can be predicted. “In reality, the effects are heterogeneous over time and across countries,” the report stated, adding that “there is no one-size-fits-all response to these crises.”

The report observed that the central bank’s monetary policy is forward-looking and has been successful at managing inflation for more than 20 years, but there is “little evidence yet that the same is currently feasible when it comes to maintaining future financial stability.”

Another issue is that “no common understanding about how to define financial instability exists,” which makes it challenging to design policies aimed at counteracting instability, according to the report.

Business cycles are also different from financial cycles, which means that a central bank tasked with managing both would have to decide “whether and when policy-rate changes represent too blunt an instrument to deal with a threat to financial stability.”

Further, there is the issue that “central banks themselves have acknowledged that monetary policy can come into conflict with the objective of financial stability.”

The report referred to the Bank of Canada’s observation that financial system conditions can impact the effectiveness of monetary policy, and monetary policy can contribute to financial imbalances, “thus magnifying the economic consequences of future adverse shocks and increasing the probability and severity of future crises.”

In its conclusions, the report stated that “a country is best prepared for a financial crisis, especially the kind that afflicted the global economy in 2008-09, when monetary, regulatory and fiscal authorities jointly respond aggressively to looming threats and consequences of financial malfeasance.”