Next to nothing: What does a central bank do when interest rates approach zero?

When Bank of Canada governor Mark Carney started cutting interest rates in March 2008, he effectively dropped a pebble in a well to see when it would hit water.

A year and a bit later, with the bank's most recent rate reduction, Carney just discovered that Canada's economic well might be empty.

On April 21, the Bank of Canada cut its overnight rate to 0.25 per cent, slashing the trend-setting borrowing charge from 0.5 per cent.

In March 2008, the bank's rate stood at 3.5 per cent.

At that time, Canada's economy was predicted to grow, albeit by a tiny amount, in 2009. Now, the country's central bank says the country's gross domestic product will shrink by three per cent.

That contradiction represents a far worse outlook than what other forecasters, including the International Monetary Fund, have predicted, and could be a sign of how badly the Bank of Canada — like Ottawa — underestimated the current economic slump. 

"Deteriorating credit conditions have spread quickly through trade, financial, and confidence channels. While more aggressive monetary and fiscal policy actions are underway across the G20, measures to stabilize the global financial system have taken longer than expected to enact. As a result, the recession in Canada will be deeper than anticipated," said the Bank of Canada in a press statement accompanying the latest rate cut.

April's cut  represented the eighth time Carney has eased rates since taking charge of the central bank in February 2008. He's also injected $40 billion in cash into the economy through asset swaps with banks, and last week took the unusual step of agreeing to accept corporate bonds as collateral to try to free up credit.

And still, the Canadian economy declines.

Canada's chartered banks haven't been as co-operative as Carney might like. They haven't always passed along the full rate cuts by reducing their own prime lending rates by the same amount.  Loans have been harder to get as the banks avoid riskier lending.

"There is clear evidence that very low interest rates are not working to expand economic activity," former Conservative cabinet minister Doug Peters wrote in a paper for the Canadian Centre for Policy Alternatives.

 "Banks are obviously worried about lending to each other and, of course, are worried about lending to consumers and firms. Interest rates that count, such as inter-bank lending rates, mortgage lending rates, bank commercial lending rates, are all unusually high, especially considering that inflation is also very close to zero."

Still, the banks appear ready to play along with the rate drop. Shortly after the April announcement, a number of charted banks, including the Royal Bank, said they would cut their prime rates in step with Canada's central monetary authority.

'The tools at their disposal are only so big and they can only do so much to offset this deep global downturn. ' — Douglas Porter, Bank of Montreal

Earlier in the year, Carney predicted a 4.8 per cent economic contraction in the first three months of this year with a quick recovery.

Now he believes Canada's economy will tumble in 2009 worse than the United States, which could see its GDP contract by 1.6 per cent, the United Kingdom, which might expect a drop of 2.8 per cent, and Japan, which could shrink by 2.6 per cent.

Carney also says he will keep rates at their current minuscule levels until the April-to-June period of 2010, an indication that any recovery will not begin before then.

"The bank now expects the recovery to be delayed until the fourth quarter and to be more gradual. The economy is projected to grow by 2.5 per cent in 2010 and 4.7 per cent in 2011, and to reach its production capacity in the third quarter of 2011," Carney wrote in a statement regarding his rate decision.

To compensate for the ineffectiveness of rate cuts, the Bank of Canada has used a plethora of new measures to try to get more cash into the economy. Here are a few:

Printing money

Most methods of getting more liquidity into financial markets come down to one thing — printing money.

Before the 1970s, most governments needed to buy gold to print more money because most national currencies were tradable for fixed amounts of bullion.

So the ability of central banks to churn cash from their own printing presses was limited.

But these days, many countries have a floating exchange system, not linked to national gold reserves.

As a result, fears of higher inflation or a devalued currency now are the main restraints on administrations and central banks that want to print more money.

Here are some of the ways central banks inject cash into the global financial system:

• Bank rate: This key interest rate is what most people recite when they speak about the Bank of Canada cutting borrowing costs. The bank rate is how much the country's central bank charges to lend to major financial institutions overnight.   
• Purchase and resale agreement (PRA): Also known as "a reverse repo," in this transaction a central bank buys securities from private-sector institutions for a specified time, at which point the deal is reversed. Typically, a central bank will hold on to the security for as little as a day or as long as a month. The private institution then buys the debt instrument back from the national bank. Since September, the Bank of Canada has expanded the type of securities it would accept as collateral to include the dreaded asset-backed commercial paper.
• Sale and repurchase agreement (SRA): This is similar to a purchase and resale agreement, except the Bank of Canada acts as seller and the private-sector firm is the buyer. "A PRA puts liquidity in [financial markets], an SRA takes it out," said one Bank of Canada official.
• Standing liquidity facility: What might sound like a piece of plumbing in fact is overdraft protection for private banks. Firms that are experiencing a cash crunch measured in hours, rather than days, can apply for this cash. Unlike other methods for increasing liquidity, the standing facility is essentially a way of helping a bank or other financial institution through a one-day rough fiscal patch rather than a way by which the Bank of Canada can assist the overall financial system.
• Asset-backed Commercial Paper Money Market Mutual Fund liquidity facility: Possibly the longest acronym in financial history, the ABCP MMMF liquidity facility is a U.S. Federal Reserve tool for assisting certain kinds of mutual funds. The central bank provides cash through this facility in return for the funds' ABCP holdings, instruments that can't realistically be sold in another market.

In January, Carney predicted the economy will expand by 3.8 per cent next year. Tuesday's statement does not officially alter that forecast, but strongly implies that both this year's 1.2 per cent contraction will be worse and that the recession may last until next year.

Still, Bank of Montreal economist Douglas Porter says there are good reasons to buy into Carney's assessment.

'The smart position [for Carney] is to cut rates … and wait and see what global central banks do elsewhere' —Derek Holt, Bank of Nova Scotia

First, interest rates are much lower now than during the previous downturns. Second, aggressive stimulus policy is kicking in. And finally, corporate balance sheets were in better shape heading into the current recession  compared with the previous two.

"There are things policy makers here can do to cushion the blow, but the tools at their disposal are only so big and they can only do so much to offset this deep global downturn," Porter said.

And that's the problem. 

Canada's main banker can be as careful and forward thinking as it's possible to be, but Canada will continue to struggle if the rest of the world does. If there is less demand for Canadian commodities, their prices will remain low. Canada's exports will continue to decline and Canadian job creation will fall along with it.

"You can cut rates to near zero, you can stimulate the domestic economy through fiscal policy, but you still need a rebound in the U.S. and European economies," said Bank of Nova Scotia economist Derek Holt. "The smart position [for Carney] is to cut rates … and wait and see what global central banks do elsewhere," Holt said earlier this year.

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