November 24, 2022
  • November 24, 2022

Bank of Canada loses money for the first time on rising rates

By on September 16, 2022 0

The central bank anticipates losses for the next three years, depending on the progress of its fight against inflation

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The Bank of Canada’s historic fight against deflation during the COVID recession, and now the surprising inflationary surge that has occurred in the wake of the recovery, will likely end the central bank‘s unblemished profitability streak. .

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“We expect the bank’s net interest income to be negative when our third quarter results are released on November 29,” the central bank said in a statement originally provided to the Toronto Star. “The bank’s interest charges are increasing due to the increase in the interest rates we pay on deposits.”

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It’s easy to forget that central banks are designed to operate like any other financial institution. The Bank of Canada has a board of directors that oversees management (Governor Tiff Macklem and Senior Deputy Governor Carolyn Rogers) on behalf of its shareholders (taxpayers, via the federal government) and it has a balance sheet with assets and liabilities.

Typically, the Bank of Canada’s balance sheet earns money because the liabilities consist almost entirely of banknotes, which do not earn interest, while on the other hand, the central bank earns interest on its assets. The Bank of Canada Act stipulates that the central bank must send its profits to the federal treasury at the end of each fiscal year. Recently, that’s about $1 billion a year.

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But the Bank of Canada Act predates quantitative easing, or QE, an anti-deflation tactic that involves creating deposits as deposits for creditors at the central bank and then using those newly created deposits to buy bonds and other financial assets. The Bank of Canada rolled out QE for the first time during the COVID crisis, flooding the financial system with the equivalent of hundreds of billions of dollars to help maintain downward pressure on interest rates and increase banks’ ability to lend money.

An unintended consequence of this policy is that, for the first time in its 87-year history, the Bank of Canada is on track to lose money for an extended period, as interest charges on deposits rise in tandem with the benchmark interest rate, which Macklem has raised by three percentage points since March in an effort to cool demand, which has helped push annual inflation to around eight percent, the highest level since the early 1980s.

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Quantitative easing has worked, and perhaps a little too well, as the economy seems to have entered a phase of “excess demand” at the same time as big supply chain problems limited the supply of goods and that Russia’s invasion of Ukraine triggered a spike in commodity prices. Canada’s consumer price index is hovering around an 8% annualized rate, compared to the Bank of Canada’s 2% target. Policymakers are now executing a hard pivot to tame inflation by raising interest rates and reversing QE by ending purchases and letting assets off its balance sheet disappear as they mature.

Some economists believe that to contain inflation, a recession will have to be triggered. While that remains to be seen, it is clear that one of the casualties will be the Bank of Canada’s net interest income, or the difference between income from interest-bearing assets and the costs of liabilities. The large-scale asset purchases that remain on the balance sheet occurred at a time when interest rates were much lower than they are today and the coupon rate on bonds was relatively higher than the rate paid on deposits.

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Initially, QE was a profitable strategy. The Bank of Canada said net interest income jumped nearly 20% in 2021 from 2020, to about $3.1 billion. The statement, provided by spokesman Paul Badertscher, noted that the central bank sent the federal government an additional $2.6 billion over those two years. But now the situation has reversed. The statement said the central bank expects losses for the next three years, depending on how its fight against inflation progresses.

The US Federal Reserve Building in Washington, DC
The US Federal Reserve Building in Washington, DC Photo by Chris Wattie/Reuters

This is a new challenge for the Bank of Canada, but it is not the only one, as most of the world’s major central banks have resorted to QE to fight the recession and now find themselves struggling to prevent the inflation to hit double digits.

In New Zealand, the government simply covers the potential losses of the Reserve Bank of New Zealand. But the Bank of Canada Act does not allow Macklem to retain net income from previous years to meet future shortfalls, nor is there a provision requiring the federal government to return the entire central bank. The problem will almost certainly be solved; Meanwhile, the Bank of Canada said in its statement that it had stopped paying interest on government reserves to reduce liabilities, noting that other central banks had done the same.

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Benjamin Tal, deputy chief economist at CIBC Capital Markets, said the Bank of Canada’s mission is not to make money and absorb a loss to avoid what could have been a terrible recession is a compromise acceptable.

“That’s their way of looking at it and there’s no impact on the economy,” Tal said in an email. “They don’t lose sleep over it.”

The Bank of Canada reiterated that it will focus on tackling high inflation and that the large-scale asset purchases the bank has undergone over the past two years coincide with its mandate to preserve welfare country’s financial.

“The bank makes policy decisions based on our mandate to keep inflation low, stable and predictable,” the statement said. “We don’t make political decisions to manage our balance sheet.”

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