The global financial crisis and its aftermath have fundamentally challenged the basis on which central banks had previously been operating, in several dimensions.
The crisis made apparent that the modeling framework which central banks typically relied on for their policy analysis was insufficient. The main modeling paradigm, New Keynesian DSGE models, has been criticised on several grounds. Many models relied on unrealistic behavioural assumptions and failed to capture pertinent features of the economy, as they were often treating the financial sector in an overly rudimentary manner, assumed linear relationships and did not allow for enough heterogeneity among economic agents. Even modeling frameworks focused on the financial sector were not well suited for anticipating or predicting the extent of the financial crisis and its effects. The behaviour of regulators, supervisors and financial markets as well as contagion and the interaction between financial markets and the real sector are all aspects of financial modeling in need of improvement.
The crisis has also changed the economic environment in which central banks operate. The behaviour of the Canadian and the global economy in the aftermath of the crisis has been surprising in several dimensions – to mention only a few, concerns about financial instability have continued to characterize the international scene; economic growth has been abnormally low; inflation has been surprisingly weak; trade collapsed and has been slow to recover. Also, the financial regulatory framework has evolved considerably, with ensuing effects on the behaviour of the regulated actors. Finally, more emphasis has been placed on macro‐prudential policies, and the interrelation of monetary and fiscal policy.
Not all changes in the economic environment have come about due to the crisis. Technological progress has altered, for instance, the payments systems landscape for both the interbank and retail sectors, with possibly profound effects on central banking.
The conduct of monetary policy has also undergone substantial changes. Unconventional policy tools have been put in place, and central banks have altered the way they communicate. The goals of monetary policy also continue to be debated, especially around questions related to the balancing of monetary policy and financial stability policy goals. As their mandates and toolboxes have broadened, some central banks have drawn criticism, with some critics worrying that such developments might politicize monetary policy.
Taken together, these developments have altered our thinking about central banking, yet many of the changes and their implications still need to be fully understood. This calls for an innovative research agenda which
- Challenges existing paradigms, such as the predominance of New‐Keynesian DSGE models and the over‐reliance on representative agent models
- Re‐balances and enriches the modeling toolbox of our policy models especially through increased financial modeling
- Improves our understanding of financial stability issues to better identify and assess vulnerabilities and risks, model incentives and behaviour, and clarify the links with the real sector
- Takes more insights from other sciences, such as psychology or natural sciences
- Clarifies the role monetary policy can and should play, what instruments it should use, and how monetary policy should interact with financial stability and other policies
- Enhances our understanding of post‐crisis economic behaviours and relationships
- Identifies and resolves data gaps
- Enables a better understanding of the implications of trends and changes that could profoundly affect economies, markets and central banks in the future
- Builds in a degree of flexibility to allow—even encourage—the element of experimentation that is a normal part of the research process.
The Bank’s 2016‐2018 Medium‐Term Plan (MTP) distils these points into a desire to reinvent how we think about the roles of central banks and the conduct of central bank policy, and puts particular emphasis on reinforcing and further developing a culture that supports innovation. This Bank-wide research plan sets out the main areas where economic and financial research can contribute to these goals – while obviously building on existing research wherever possible.
The plan is structured along the main challenges identified in the Bank’s MTP. Organized by topics rather than by departments, the research plan strives to identify potential for cross-departmental and cross‐functional synergies in the Bank’s research.
Advancing the frontiers of monetary policy
1. Monetary policy after the crisis
Several years after the global financial crisis, neither the Canadian nor the global economy is back to normal. Central banks in several advanced economies are still conducting unconventional monetary policies in order to support their ailing economies.
In Canada, even though the economy is expected to show a stronger momentum within the next few years, progress has been rather timid as we have yet to see a more robust global economic recovery. Against this background, it is crucial to learn the lessons from the past crisis and understand how monetary policy can be improved going forward.
As a public institution, it is incumbent on the Bank to continuously explore ways to improve its monetary policy framework. One avenue of this exploration is and has been an examination of the efficacy of alternative monetary policy frameworks such as price level, average inflation or nominal income targeting. Another avenue includes potential improvements to the current inflation targeting regime, an area that features prominently in the work related to the renewal of the inflation targeting agreement in 2016. For example, it has been argued that the inflation target should be increased, given the recent experience with the effective lower bound and evidence that the real neutral interest rate may have declined. In considering this proposal, it is important to thoroughly examine its costs and benefits and to understand how the transition to a different target level could be managed.
The changing role of monetary policy during the crisis has also had substantial effects on the way central banks communicate with their various stakeholders, and how central they have become to the public economic debate. This leads to questions with regard to the optimal degree of transparency, and the relevant communication channels that central banks should pursue.
- re‐assess the ability of monetary policy to stimulate the economy given that, after years of expansionary policy, the recovery in many economies still remains tepid—especially in countries whose financial systems were impaired or had to undergo significant deleveraging;
- study the effects and effectiveness of the introduction of and exit from unconventional monetary policies;
- analyse the experiences of central banks that introduced unconventional monetary policies, and come to a view on to what extent they should become part of a central bank’s standard toolkit;
- focus on the effectiveness of unconventional monetary policy in the context of a small open economy—most of the existing literature is based on data from the US, with a few studies on countries like the UK;
- look into different types of unconventional measures, including large-scale asset purchases, forward guidance and negative policy rates;
- assess the level of the effective lower bound in Canada, its implications for monetary policy implementation and the financial system;
- look at the macroeconomic and policy implications of low policy interest rates in Canada and internationally.
2. Nexus between financial stability and price stability, and its implications for monetary policy
As demonstrated by the global financial crisis and its repercussions, macroeconomic stability is a necessary but not sufficient condition for financial stability, while a stable, efficient and well-functioning financial system contributes importantly to a healthy economy. Consequently, financial stability considerations are an important element of the monetary policy framework. On the one hand, financial system conditions can affect the effectiveness of monetary policy; on the other, monetary policy can contribute to the build‐up of financial imbalances and thus influence the probability and severity of future crises. Furthermore, the need for monetary policy intervention to address financial stability concerns depends on the stance of micro‐ and macroprudential policies and their effectiveness in preventing the realization of such states of the world.
- improve our assessment of the costs and benefits of using monetary policy to support financial stability by enhancing existing policy models (e.g. MP2) and developing models that incorporate new real‐financial linkage channels and account for non‐linearities in economic responses;
- develop a framework to address the impact of monetary policy on tail risks in financial markets;
- advance our understanding of the effectiveness of macroprudential policies in mitigating systemic risks and their implications for monetary policy;
- study the optimal mix of monetary, macroprudential and fiscal policies, including their interactions and co‐ordination;
- draw insights from central bank experiences in managing the complex trade‐offs between price stability and financial stability goals.
3. Improve our understanding of the post‐crisis Canadian and global economy, and of commodity markets
The behaviour of the Canadian and the global economy in the aftermath of the crisis has been surprising in several dimensions. Economic growth has often been underwhelming, despite substantial policy accommodation, especially in countries whose financial systems were impaired or had to undergo significant deleveraging. This raises questions about the evolution of potential output, and about the role of uncertainty and expectation formation in macroeconomic dynamics. The evolution of inflation has been surprising, too, first along the lines of a “missing disinflation”, and subsequently because inflation was surprisingly weak. Also the great trade collapse after the crisis and the subsequent slow recovery of trade are still not fully understood, and the persistence of the recent decline in commodity and particular oil prices has surprised many observers.
It is therefore imperative to improve our understanding of the economic dynamics in Canada and globally. Canada and other advanced economies expanded into high‐value added services, and globally, there are major changes in the structure of production. Both factors have ensuing effects on growth and trade patterns. Developments in Canada’s key global competitors in the export sector are of particular importance in this regard.
- study net and gross capital flows, the global financial cycle, trade links and spillovers across world regions;
- analyse the implications of diverging monetary policy for the global economy, and consider to what extent we should expect to see more spillovers arising from emerging market economies;
- identify new techniques and data that allow us to more accurately estimate potential output, productivity and labour market slack, and understand how they relate to inflation;
- study the determination of exchange rates and their effects on trade and inflation;
- examine how economic agents form expectations, how these affect inflation dynamics, and the role that uncertainty plays in shaping macroeconomic dynamics.
Other key considerations:
The household sector is also of relevance to an enhanced understanding of the economy. Household behaviour has likely changed after the crisis in several aspects, including savings behaviour, labour force participation, or household finances. The distribution of income and wealth has also likely changed, with implications for savings and consumption. Furthermore, demographic changes affect potential output, consumption and the financial behaviour of households. Finally, developments in the housing market have repercussions on consumer behaviour. All of these factors need to be well understood, as they affect monetary policy and possibly also financial stability.
Small and medium‐sized enterprises (SMEs) are known to be the engine of growth for an economy, accounting for 80% of the creation of new jobs in manufacturing in Canada. While this sector is important, it is also volatile with some firms growing rapidly and many firms entering and exiting. Given that SMEs typically face more funding difficulties than their larger counterparts, questions remain regarding SMEs’ access to funding and its impact on their startup, growth and failure. Furthermore, conditional on data availability, we will evaluate the role of federal crown corporations (e.g. BDC, Farm Credit Canada) in the firm creation space and seed capital. Research in the area tries to enhance our understanding of the contribution of SMEs to potential output, elaborate the role of SMEs in the transmission of monetary policy and gauge the importance of funding constraints on SME performance, defaults and bankruptcies.
With regard to commodity markets, important questions relate to the inter‐linkages between financial and physical commodity markets and cross‐market correlations, as well as commodity super‐cycles and the determinants of commodity prices. In addition, it is important to understand better the current dynamics in quantities (i.e. supply and demand), such as the changing role of Saudi Arabia and OPEC more generally for oil supply, the flexibility in shale oil production, or plans among the G20 to phase out fossil fuel subsidies. Given the importance of commodities for the Canadian economy, this will have implications for Canada as a whole, but will affect the regions in a different fashion.
Commodity prices also link back to the labour market – for instance, high oil prices have led to movements across occupations and regions, and might have led the young to enter the labour market early, thus affecting their educational attainment, with possibly long‐lasting effects on their employability. Accordingly, it is important to study adjustments to commodity price shocks, with a view to understanding how best to facilitate the adjustment.
4. Develop the next generation of models to inform policy
The analysis of macroeconomic as well as financial developments in Canada and abroad and their policy implications crucially depend on the quality of the tools and models used. The crisis has highlighted several shortcomings in our model framework, related inter alia to the underlying behavioural assumptions, a minimalistic modeling of the financial sector and a failure to account for existing non‐linearities and heterogeneity across agents.
- assess whether alternative model paradigms like agent-based models should be implemented, and if so whether these should be a complement or a substitute to the mainstream DSGE models and financial stress‐test models;
- exploit small state‐of‐the‐art models that can be tailored to selected areas or mechanisms of interest (e.g., forecasting versus policy analysis, smooth versus regime‐switching dynamics, small versus large disturbances or crises);
- explore more realistic behavioural assumptions (e.g. with regard to the role of uncertainty and expectations for understanding macroeconomic dynamics);
- utilize more sophisticated solution methods that more accurately account for drastic economic events;
- explore new techniques and sources of data for forecasting and nowcasting important Canadian and international macroeconomic variables.
At the same time, we will work towards improving the existing models: Given the importance of commodity prices for the Canadian economy, we will enrich our models with regard to the determination of global oil and non‐energy commodity prices, their link to the Canadian economy and the Canadian dollar. Due to the openness of the Canadian economy, this research will also improve the current modeling framework with regard to interactions and trade links among regions in the global economy and to capture the impact of global macroeconomic, financial and policy developments on the Canadian economy and their policy implications.
Incorporating financial stability considerations
1. Identify vulnerabilities and analyze risks to financial stability
In order to incorporate financial stability considerations into the Bank’s policy advice and operations, it is important to enhance our capability to locate the major fragilities in the financial system, how they are evolving over time, and how different shocks could interact with those fragilities to disturb the smooth functioning of the financial system.
To that effect, the Bank recently introduced a risk‐assessment framework that aims to provide more discipline in identifying vulnerabilities in the Canadian financial system and more quantitative rigor in assessing the probability and severity of relevant financial stability risks. Although progress has been made in developing and operationalizing this framework, much work remains. And our understanding of systemic risks outside of the regulatory perimeter, in financial markets and the real economy remains in its infancy.
- address data gaps identified in the vulnerability assessment process and further enhance our risk‐assessment framework by constructing and integrating models and tools to complement our qualitative judgement (e.g. probability of risk scenario) for a broader set of sectors and markets;
- deepen our understanding of vulnerabilities and risks arising in the shadow‐banking sector, and to see whether risks could also arise in the corporate sector. Large swings in financial market prices are part of the nature of markets, hence it is not straightforward to differentiate the normal price discovery process from asset price bubbles;
- deepen our understanding of current vulnerabilities in the Canadian financial system. For instance, we will take a more granular look at the distribution of household debt and characteristics of indebted households to gain insights on the debt‐repaying capacity of vulnerable households—and hence the extent to which household indebtedness poses a systemic risk to financial stability in Canada;
- enhance our understanding of the mechanism through which liquidity and credit risks transmit financial shocks to the broader economy;
- investigate vulnerabilities arising from the interconnectedness between economic sectors, financial infrastructures, markets and institutions.
2. Evaluate the impact of regulatory changes
Since the financial crises, sweeping global reform of the financial regulatory and supervisory framework has taken place. Key elements of the reform agenda included: enhanced transparency and disclosure; higher capital, liquidity and leverage standards; credible and effective resolution regimes for large financial institutions; enhanced regulation and more intense supervision of all systemically important financial institutions; stronger infrastructure for key financial markets; and measures to promote adherence to international prudential regulatory and supervisory standards. Also, to protect the banking sector from periods of excess aggregate credit growth that have often been associated with a build‐up of system‐wide risk, a new macroprudential tool, the countercyclical capital buffer, has been included in Basel III.
- assess the impact of some of these regulatory changes;
- study the optimal design and degree of complexity of banking capital regulations as well as their effectiveness in reducing systemic risk, including the effect of the introduction of resolution regimes on market perception of too‐big‐to‐fail of the systemically important institutions, how the effectiveness varies across countries with different resolution regimes, and how the initial impact of bail‐in policies can be identified using financial market instruments;
- investigate possible unintended effects on the efficiency/competitiveness of the Canadian financial system as well as on the shadow-banking entities and activities;
- deepen our understanding of the behaviour/reaction of financial institutions to regulatory changes and the potential for regulatory arbitrage and international regulatory spillovers;
- assess the impact of these regulations on the liquidity of Canadian bond markets, given they require more transparency in financial instruments and market transactions;
- explore the implications of the potential treatment of sovereign risk under Basel Committee on Banking Supervision on monetary policy implementation and transmission. And, more generally, to what extent the regulatory changes have mitigated financial stability concerns, thereby possibly reducing the need for monetary policy to incorporate financial stability considerations.
3. An evaluation of the strategic direction of the Government’s domestic debt program
As the result of regulatory reforms to promote financial stability and the emergence of the Canadian dollar as a reserve currency after the country’s relatively strong performance during the financial crisis, the demand for Government of Canada (GoC) securities has increased significantly both from domestic and foreign (public and private) investors. At the same time, the Government projects fiscal surpluses in the near future and is targeting a declining debt stock in the medium term. The increased demand and potential reduction in supply raise questions related to the optimal level and structure of public debt, in particular because these debt securities have additional uses apart from financing the Government. Examples of alternative roles for government debt include having a risk‐free yield curve to price other financial instruments, serving as collateral to satisfy increased regulatory requirements for financial institutions, and providing an asset that the central bank can use in its regular as well as any possible unconventional monetary policy operations.
- deepen our understanding of the social value that GoC securities provide (particularly in relation to promoting financial stability), the functioning of their secondary markets, and the behaviour of agents in those markets. This will allow the Bank to provide the Government with policy advice on the issuance pattern and debt stock that is consistent with well‐functioning markets, while considering the trade‐offs between cost and risk.
- study what implications a given stock of GoC securities has for monetary policy.
Ensuring sound and effective payments
1. The demand for cash and implications of new payment systems and technologies
There has been rapid technological change in the field of electronic money and payments over recent years and the trend is likely to continue. These developments have the potential to fundamentally change how we pay for goods and services not only via the internet but also in traditional point of sale transactions. By providing an alternative means of payment to the cash issued by the Bank of Canada, there are direct implications for the demand for physical Canadian dollar notes which could significantly impact the size of our balance sheet and seigniorage revenue. Beyond the growing usage of alternative payments, other factors such as the underground economy, demographics or interest rates also affect the demand for cash. Data collected from consumer surveys on method of payment behaviours, and internal data on circulation flows of bank notes will be used to study current and future trends of bank notes demand and usage.
But the potential implications of widespread usage of electronic money and payments are broader than that. There could be significant implications for existing systemically important payment systems or for the regulation of these new payment schemes. There could also be important implications for the functioning of traditional financial institutions if lending and savings patterns are affected, which in turn could have repercussions for financial stability.
- better understand these trends in adoption and usage and their implications for central bank policies related to currency issuance, systemically important payment systems, financial stability, and monetary policy;
- investigate the question of whether the Bank should consider issuing its own digital currency, what it would look like, and how we would go about it;
- help the Bank build a policy framework for new electronic money and payment schemes.
2. Support changes to strengthen Canada's financial market infrastructure
Financial market infrastructures (FMIs) are at the heart of every country's financial system. They facilitate the clearing, settling or recording of payments, securities, derivatives or other financial transactions. They allow consumers and firms to safely and efficiently purchase goods and services, make financial investments and transfer funds. As such, they play a fundamental role in achieving an efficient and stable financial system.
Currently, FMIs are undergoing major transformation caused by different drivers of change such as the growth of the international flow of goods and services, new financial regulations (e.g. the Principles for Financial Market Infrastructures‐PFMIs), and the continuous change of digital technologies.
- understand the implications of these transformations and support changes to strengthen Canada’s financial market infrastructure;
- support the Canadian Payments Association in the modernization of the core Canadian payment systems (ACSS and LVTS) and improving cross‐border payments system integration;
- inform the implementation of oversight standards for designated payment, clearing and settlement systems, namely, the PFMIs;
- inform the development of a resolution framework for FMIs.
Considering the implications of alternative futures
1. Anticipating the implications of big trends and changes on economies, markets and central banks
The Bank needs to anticipate big trends and changes that could profoundly affect economies, markets and central banks. Research will be devoted towards considering the implications of such alternative futures. Typically, these are more extreme versions of scenarios that are considered under the above-mentioned topics, i.e. there are ongoing trends that, if taken to the extreme, could have much starker implications for central bank policies. A major challenge in this regard is to select the type of scenario to study, given the multitude of possible developments and the difficulty of quantifying their probability and the size of their impact. Hence, the scenarios below provide illustrations rather than a comprehensive list of those that will eventually be explored.
- One such development is the ongoing transformation of the international monetary and financial system. In particular, the growing importance of emerging market economies is already changing the global economic order. Alternative futures could arise that see the internationalization of the RMB and a major shift in reserve currency holdings challenging the dominant role of the U.S. dollar, while at the same time seeing monetary institutions that are more strongly influenced by emerging markets gaining importance. Useful lessons for such a transformation might be learned from earlier examples in history.
- The mirror image of the growing importance of emerging markets in the global economy is the disappointing post‐crisis recovery in advanced economies. Slow growth and low inflation have led to concerns that these countries might be facing secular stagnation, with ensuing implications for the conduct of monetary policy. While still a low‐probability scenario, research will attempt to assess the implications should it materialise.
- A number of scenarios that can have profound effects on the Canadian economy relate to technological progress. Fracking, for instance, is giving rise to increased energy production in the United States, to a point where the United States could become a net exporter of energy. U.S. energy independence would have implications for Canada, given that energy accounts for roughly a quarter of all exports and the oil and gas industries account for a large share of private business investment. Trading with an economy that is moving down the value‐added chain might also present new challenges for Canadian exporters. Even further, we might witness technological change that drives oil prices down to levels at which most Canadian production becomes ultimately unprofitable.
- Another example of the confluence of technology and macroeconomy is the development of 3D printing in the construction sector. The capabilities of 3D printing have evolved rapidly – printers can now build larger components and achieve greater precision at higher speeds and lower costs than in the near past. Dutch and Chinese engineers have already built large‐scale printers capable of building (or “printing”) a small house in less than a week. This could have profound effects on the construction sector’s productivity and level of employment as well as on average house prices. These effects could have significant implications for potential output and, to the extent that significantly lower house prices imply smaller mortgages, the effectiveness of monetary policy via the housing market. 3D printing could also result in widespread reshoring of manufacturing, with profound implications for the volume and direction of international trade.
- Taking technological progress in payments to the extreme, we might see a cryptocurrency starting to supplant Bank of Canada‐created money as a dominant unit of account, medium of exchange and store of value; alternatively, entirely cashless societies might emerge. The disappearance of cash could help in reducing the underground economy, thereby affecting the economic environment within which central banks operate. Also, it would affect the relevance of the effective lower bound. In this context, we will analyse the feasibility and desirability of various proposals to remove the effective lower bound for monetary policy by reducing or eliminating cash.
- Finally, taking the current plans to target a declining stock of GoC debt to the extreme, it is worthwhile studying a future where Canadian government debt vanishes, along with the implications of this scenario for financial markets and monetary policy.
- Yet another set of scenarios relates to the Bank of Canada itself. Several possibilities could be looked at, such as Canada joining a monetary union with the United States, the Bank issuing e‐money, the Bank taking on a macroprudential role, or the Bank changing its governance.
Enhancing innovation and knowledge sharing
1. Explore and exploit the potential of novel data sources
Traditionally, monetary policy decisions are informed by economic data based on surveys and administrative records and are released with a delay. The increasingly widespread use of the internet by consumers, retailers and social‐media users, however, has led to the creation of novel and potentially useful data sources to serve as a complement to traditional data.
These “big data” open up interesting avenues of research that can lead to a clearer understanding of the behaviour of economic agents ‐ a fundamental prerequisite to effective monetary policy making. Prices collected from retail websites, for instance, can be used to study pricing behaviour. Social media, combined with the fact that an entire cohort of economic agents are now expressing their views online, may become an important source of data to understand the perception and credibility of monetary policy. Internet‐based transactions such as the emerging peer‐to‐peer lending can obviously only be understood using big data, and space satellite data could become useful in studying economic growth.
Research is also increasingly exploiting more granular data such as high‐frequency data, which can help better understanding of behavioural patterns in financial markets, or micro‐level data which are essential to studying the behaviour of heterogeneous groups of economic agents. For example, studying the implications of household debt requires household‐level data, as it is important to identify the characteristics of vulnerable households and to understand their behaviour. More generally, comprehensive data on household consumption, wealth and income from one data source would be extremely powerful. Given that no such data source exists, the Bank might want to consider initiating a corresponding survey.
Micro data on retail prices can provide insights on how CPI inflation responds to monetary policy; and data on prices of importers and domestic producers can shed light on the degree of the exchange rate pass-through to domestic prices.
Finally, historical data can be usefully employed to study the implications of rare events such as crises, for which only few observations are available over more recent time spans.
2. Generate synergies among users of similar data / methodologies
Research on the various topics outlined above can possibly be improved substantially if the Bank manages to generate more synergies among users of similar data or methodologies across the Bank’s different departments and functions.
One example for this relates to survey data, which are used in several different areas. Expertise in survey design, detailed knowledge about particular surveys, as well as experience in applying econometric approaches to analyse survey data can be shared among users, and synergies between related surveys can be explored (such as the Cost of Payments Survey and the Business Outlook Survey, as well as other business surveys or the 2016 Method of Payment Survey and the Survey of Consumer Expectations).
Another example relates to the above‐mentioned SME‐related research, where researchers in different parts of the Bank can enhance their research by improving collaboration.
In line with this objective, the establishment of working groups, or “think tanks” that cut across departments and functions, is foreseen in several areas of the research agenda.