Cutting to Zero

The Bank of Canada should announce a target interest rate of 0% on Tuesday. This move would match the action taken by the US Federal Reserve a month ago.

Recent experience suggests that the chartered banks would not pass along the entire cut. But such a dramatic announcement by the Bank of Canada would place strong pressure on the chartered banks to noticeably reduce their interest rates.

Even so, there is legitimate doubt about how much stimulus lower interest rates can deliver in an environment where financial institutions are reluctant to lend while businesses and consumers are reluctant to borrow. Nevertheless, the Bank of Canada should go as far as it can in providing stimulus through lower interest rates.

The usual reason for maintaining or increasing interest rates is to limit inflation. However, the faint possibility of rising inflation has been overtaken by the spectre of deflation.

Canada’s economy is now in recession. Since Statistics Canada’s System of National Accounts began in 1961, there have been two years in which real GDP shrank. In the 1982 recession, the inflation rate immediately dropped by 5.1% and then declined by a further 1.8% before bottoming out three years later.

In the 1991 recession, inflation immediately dropped by 4.2% and then declined by a further 1.3% before bottoming out at 0.1% three years later. (Indeed, Canada had a brush with deflation in 1994, when the year-over-year CPI rate was slightly negative for three months.)

Annual CPI Rates After Recessions


Initial Rate

One Year Out

Three Years Out


 10.9 %

 5.8 %

 4.0 %


 5.6 %

 1.4 %

 0.1 %


We will not know the precise annual inflation rate for 2008 until Statistics Canada releases the December numbers a week from today. But the average during the first eleven months of 2008 was 2.5% and, if anything, the December numbers will slightly reduce this average.

From this low starting point, a decline in inflation anything like the last two recessions (-5.1% and -4.2%) would push Canada well into deflation during 2009. Already, we have seen the year-over-year inflation rate drop by 1.4% in two months since September.

To prevent a deflationary spiral, formerly conservative economists like Ken Rogoff and David Laidler have proposed that the Bank of Canada print money and inject it into the economy by buying government bonds. Whether or not such unorthodox monetary policy is needed, the Bank of Canada should at least do all it can to avert deflation by cutting interest rates.

An obvious retort is that inflation fell so much during the last recessions because the Bank of Canada targeted double-digit interest rates for the purpose of quashing inflation. With interest rates already far lower, inflation is arguably unlikely to drop as much now as it did then.

However, it’s important to remember the avenue by which interest rates affect inflation. To quote the late, great J. K. Galbraith, “monetary policy must work, if at all, by reducing the aggregate demand for goods” unless one has a “faith that, by essentially occult means, monetary policy will stabilize prices without affecting the volume of producer borrowing, investment and spending.”

In the early 1980s and early 1990s, interest rates did not reduce inflation by occult means. They reduced inflation by reducing producer borrowing, investment and spending.

Despite lower interest rates, we are now experiencing a reduction in producer borrowing, investment and spending and will presumably also experience the corresponding downward pressure on prices. To mitigate this downward pressure and prevent deflation, the Bank of Canada should do what it can to boost producer borrowing, investment and spending.

Even if deflation does not materialize, the history of recent recessions suggests that there will not be much threat of rising inflation for the next few years. So, the Bank of Canada should feel free to keep its interest rate at 0% at least until real GDP is increasing again.

Some influential commentators, such as Bill Robson of the C. D. Howe Institute and Andrew Coyne of Maclean’s magazine, are still arguing that fiscal stimulus is unnecessary because central banks can get us out of the soup with monetary policy alone. If Robson and Coyne are correct, then the Bank of Canada should act quickly to give the Canadian economy the monetary jolt it needs before governments go too far down the deficit road.

If Robson and Coyne are wrong, then the Bank of Canada should demonstrate that interest rates have gone as far as they can and confirm the need for fiscal policy. Either way, the country would be best served by the Bank of Canada targeting a 0% interest rate sooner rather than later.


  • yes. good arguments.
    though i think the time for experimentation is now past. The rate needs to be lowered and we need what you’ve called the ‘unorthodox’ option, proper use of the Bank of Canada.

    In fact at this point, given the intransigience of Harper and his cohorts, and others internationally,it’s becoming clear that we’re going to need a lot more voices, like Travis’, at tables. hopefully with choices of language/descriptors that are accessible for the majority.

  • Armine, Mario Mark L. and I had a debate through email on this question before christman. Armine raised the spectre of a liquidity trap. Since Banks seem to be rationing credit, its not a question of the level of interest rates. Public spending and lending in such a scenario would be the prefferred solution.
    Since this debate I have been reflecting on the problem of household debt and the role it will play in keeping consumption low in the coming years. As household incomes become fragile, household debt will gain weight and become a greater strain. Households will be tempted to pay down debt, and this will strain even further consumption levels. Thats why (among other reasons) many of us do not support tax cuts as a means to stimulate growth, they will be used to de-leverage households. Some might say that that’s not a bad thing. That got me thinking how we could offer a progressive solution to this problem. We probably still have anti-usury laws that fix maximums on interest rates. I’m thinking that we could “modernize” these in the following way, different loan classes would be identified and for each loan class a maximum spread between the Bank of Canada’s target overnight rate and bank interest rates would be fixed by a public authority. It’s an old idea called “directed” credit. That way we could lower the interest cost of household debt without cutting into consumption expenses. Eventually we could use this measure as a postive tool to direct credit in certain directions. An equivalent spread could be imposed on business loans, but that’s a whole other ball game.
    For a more complete version of this in French and a long rant against the tax cuts favored by the banks see this page:

  • Leigh said:

    “we’re going to need a lot more voices, like Travis’, at tables. hopefully with choices of language/descriptors that are accessible for the majority.”

    How ’bout: We built it, it’s ours, let’s take it over!

  • I’m pretty skeptical about how much a target rate of zero would achieve–and I see you also show a certain amount of doubt about this. Yes, real interest rates may rise if there is deflation, but I’m not convinced that a nominal target of zero will spur much more lending. As was recognized in the 1930s, this can be like “pushing on a string” and could end up in a liquidity trap situation, as Eric mentioned. Over-reliance on monetary policy and too-easy credit helped to put us in this economic and financial crisis and so I don’t see how the same thing will get us out. Lowering the central bank lending rate won’t necessarily get the banks to lend more. We’re in a pretty severe credit crunch: reductions in nominal interest rates aren’t having much of an impact and could even lead to some perverse reactions if lenders react to lower rates and still high risk by tightening up credit.

    Instead, we need more emphasis on the fiscal side, support for households, and more interventionist policies such as the anti-usury measures suggested by Eric. In addition to greater direct investment in public infrastructure and public services, federal and provincial government should direct strategic investments in the private sector and also increase direct lending through the BDC, other lending agencies and even through the Bank of Canada. More fundamental structural reform and re-regulation of the financial sector is also needed, but that’s another big discussion….

  • I agree that fiscal policy is a more important response than monetary policy, but the two are not mutually exclusive. The fact that lower interest rates might be ineffective does not mean that they should not be attempted. If even the lowest possible interest rate (0%) proves to be ineffective, then the case for fiscal stimulus will be even more compelling.

    The Bank of Canada needs to announce a target interest rate on Tuesday. It may as well swing for the fences.

  • Toby touches on a very neglected subject. What can be done outside of traditional monetary and fiscal stimulus.

    Lets consider the following. Given the size our our economy, how much of an impact can monetary policy have combined with a large fiscal stimulus.

    These will help, but we do have to consider that neither will be adequate enough to get at the root problem that Toby has circled. Consumer debt, and inadequate consumption.

    So where are the solutions. We can either hope for exports to dramatically rise and lift our boats, but given our largest trading partner is pretty much in the same boat, this is highly unlikely for a good 3- 5 years at a minimum.

    We can hope that somehow magically our resource based economy is transformed and a larger share of our wealth is generated from a more diversified global value chain. Typically this would mean expansion in manufacturing or service based industries. Given the small open economy we have, we could attempt to develop a hyper innovative (preferably green based) national value adding strategy. It would have to be highly motivated from a substantive industrial policy.

    This to me is a feasible strategy, but would take a quite complicated private public/ herculean effort.
    We have the technology, the education and workforce, but we lack a industrial strategic capcity from both the public and private.

    Given the record foreign based takeovers and the demise of some our corporate jewels like Nortel, casts a fairly dark shadow over this route. There is a large high value global product and ser4vice market. But it takes asset development to hive off some large slices. It seems as though the only way forward that the current Harper regime has is let global market forces dictate. And that has only further stripped our manufacturing base and takeover of the ownership in our resource sector.

    So for me, te solution to the economy, is to get back and further push the high value adding, high wealth generating, high innovation, high wage economic development strategy. This will in turn increase productivity, which loosely translates to higher wages and consumption based upon a more progressive, green based future.

    Sure this is highly goal oriented ethereally based policy talk. But a national vision is needed. It has been needed since the globalization of our economy has made us unable to protect ourselves from such disruptive forces.

    Without this, I really don;t see much but Jim S.’s L shaped economic future.



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