Mark Carney: Living with low for long
Remarks by Mr Mark Carney, Governor of the Bank of Canada, at the Economic Club of
Canada, Toronto, 13 December 2010.
* * *
Introduction
I would like to thank the Economic Club of Canada for this opportunity to reflect on the
current economic and financial trends. I am sure many in this room would like me to stop at
the title, "Living with Low for Long," so you can go merrily into the Christmas holidays,
content that I have just provided an early present of extraordinary guidance on future
Canadian monetary policy. However, I am not bearing gifts today. Canadian monetary policy
will continue to be set, as it has in the past, for overall Canadian conditions and guided by
our 2 per cent inflation target.
In my remarks today, I will focus on the factors that have led to a low-interest-rate
environment in major advanced economies, and the implications of this environment for
financial stability and economic growth.
Global economic outlook
Current turbulence in Europe is a reminder that the crisis is not over, but has merely entered
a new phase. In a world awash with debt, repairing the balance sheets of banks, households
and countries will take years. As a consequence, the pace, pattern and variability of global
economic growth is changing, and Canada must adapt.
For the crisis economies, the easy bit of the recovery is now finished. Temporary factors
supporting growth in 2010 - such as the turn in the inventory cycle and the release of
pentup demand - have largely run their course. Fiscal stimulus is turning to fiscal drag and, for
some countries, rapid consolidation has become urgent. Household expenditure can be
expected to recover only slowly. This all implies a gradual absorption of the large excess
capacity in many advanced economies.
This is not surprising. History suggests that recessions involving financial crises tend to be
deeper and have recoveries that take twice as long. In the decade following severe financial
crises, growth rates tend to be one percentage point lower and unemployment rates five
percentage points higher.1 The current U.S. recovery is proving no exception.
In such an environment, very low policy rates in the major advanced economies could be in
place for a prolonged period - a possibility underscored by the recent extensions of
unconventional monetary policies in the United States, Japan and Europe.
This tendency towards low-interest rates is being reinforced by structural forces. The global
economy is rapidly becoming multi-polar, with emerging-market economies now driving
commodity prices, representing almost one-half of all import growth, and accounting for
about two-thirds of global growth.
This is an increasingly uneasy emergence. Growth strategies reliant on exports and excess
national savings are unsustainable in the long term. In the near term, for many emerging
economies, the limits to non-inflationary growth are approaching and the challenges of
shadowing U.S. monetary policy are increasing.
With currency tensions rising, some fear a repeat of the competitive devaluations of the
Great Depression. However, the current situation is actually more perverse. In the 1930s,
countries left the gold standard in order to ease monetary policy, and the system became
more flexible.
Today, the process is working in reverse. The international monetary system is sliding
towards a massive dollar block. Over a dozen countries are now accumulating reserves at
double digit annual rates, and countries representing over 40 per cent of the U.S.-dollar trade
weight are now managing their currencies.
This death grip on the U.S. dollar is reducing the prospects for rebalancing global demand.
As the Bank of Canada has argued elsewhere, the potential costs are huge - to $7 trillion in
lost global output by 2015.2
Ultimately, excessive reserve accumulation will prove futile. Structural changes in the global
economy will yield important adjustments in real exchange rates. If nominal exchange rates
do not change, the adjustment will come through inflation in emerging economies and
disinflation in major advanced economies.
This more wrenching adjustment has already begun, raising the risk of debt deflation and
deficient global demand. At a minimum, this dynamic reinforces the low-interest-rate
strategies of major advanced economies and may necessitate further rounds of quantitative
easing.
So what does this mean for countries caught in the middle, like Canada? I will review three
aspects:

the effect of the second round of quantitative easing (QE2);

the implications for Canadian monetary policy; and

the potential financial stability implications of "low for long" interest rates.
QE2 and implications for Canada
Last month, the Federal Reserve launched a new program to buy US$600 billion in
longerterm treasury securities by the end of the second quarter of 2011.3
It is doing so because, even though its policy rate has been effectively zero for two years, the
Fed is still missing both legs of its dual mandate to foster price stability and maximum
employment. Core inflation is at an all-time low and unemployment is unusually high. The
spectre of large structural unemployment threatens.
QE2 is designed to support the economy through easier financial conditions. In theory, by
putting downward pressure on longer-term U.S.-Treasury rates, the program stimulates
interest-sensitive sectors of the economy such as housing and business investment. Portfolio
rebalancing should encourage investors to shift towards riskier assets such as corporate
debt and equities. This in turn increases financial wealth, which supports spending. In
contrast, some financial investment may shift to harder assets such as commodities, which
would reduce the disposable incomes of Americans.
The exchange rate is another important channel. As returns on U.S. assets fall, investors
could seek alternative investments outside the country, weakening the currency, boosting
exports and curbing imports.
Finally, and importantly, expectations of higher growth should help increase inflation
expectations towards a range consistent with the Fed's mandate. This keeps real interest
rates down, which encourages investment and spending.
Of course, the exact impact of the program is hard to discern as QE2 is not the only news in
financial markets. Since the policy was first mooted by Chairman Bernanke in August, all the
expected effects have been evident, supporting the Fed's rationale. Since the November
announcement, U.S. financial conditions have improved only slightly, reflecting the conflicting
forces of some better U.S. data, heightened risk aversion caused by the European turmoil,
possibly revised expectations regarding the ultimate size of the program, and the
announcement of a major new fiscal package. The overall impact of QE2 may be more
modest than previous interventions when market dislocations were more severe.4
The Bank of Canada anticipated the Fed's latest move when we published our October
projection (not hard to do, given the openness with which the Fed discussed its plans).
Overall, we expect the net impact on Canadian GDP to be positive but small. This balances
the impact of stronger U.S. growth on demand for Canadian goods and services, as well as
on our terms of trade, with the possibility of further drag on non-commodity exports arising
from the persistent strength of the Canadian dollar.
Canadian monetary policy
While the Canadian economy is importantly affected by developments in its largest trading
partner, Canadian monetary policy is set for overall Canadian conditions and is guided by our
2 per cent inflation target. Given that the United States was the epicentre of the financial
crisis and that the Canadian financial system has continued to function well, it is not
surprising that our two economies have performed very differently. It is entirely appropriate
that our monetary policies have diverged somewhat.
Consider the responses to the extraordinary monetary and fiscal stimulus enacted in the
wake of the crisis.

Canadian output has now surpassed its pre-crisis peak (a situation unique in the
G-7).

Canadian final domestic demand has grown by 5.7 per cent since the trough of the
crisis - more than twice the rate (2.6 per cent) in the United States.

The Canadian economy recovered all of the jobs lost in the recession and added a
further 23,700; the U.S. economy has recovered only one-tenth of jobs lost, while
over 40 per cent of unemployed workers have now been out of work for more than
half a year.

Household credit has grown by about 7 per cent in Canada since the trough in GDP;
in the United States, it has fallen by 3.5 per cent.

The most recent rates of core inflation were 1.8 per cent in Canada versus
0.6 per cent in the United States.
It is not all good news. The weak links in the Canadian economy have been poor productivity
growth and declining export competitiveness. As the Bank has emphasised in recent months,
a rotation of demand from household expenditures to business investment and net exports
will be important to a sustained Canadian expansion. In this regard, much remains to be
done.
Since the spring, the Bank has unwound the last of its exceptional liquidity measures,
removed the conditional commitment, and raised the overnight rate from 0.25 per cent to
1 per cent. Last week, the Bank maintained its target for the overnight rate at this level.
This decision leaves considerable monetary stimulus in place, consistent with achieving the
2 per cent inflation target in an environment of significant excess supply in Canada. Any
further reduction in monetary policy stimulus would need to be carefully considered.
Historically low policy rates, even if appropriate to achieve the inflation target, create their
own risks. Aside from monetary policy, Canadian authorities will need to remain as vigilant as
they have been in the past to the possibility of financial imbalances developing in an
environment of still-low interest rates and relative price stability.
I would like to spend the balance of my time on the more general issue of how the perception
of low rates for long could potentially distort behaviour in public, financial, corporate and
household sectors.
Implications for sovereigns
In some countries, low interest rates may delay necessary fiscal consolidation.5 By shifting
their debt profile towards shorter-term financing, governments reduce interest rate payments.
The substantial purchases of longer-term government bonds by foreign and domestic central
banks could delay market signals about debt sustainability.6 While low current interest rates
create short-term fiscal flexibility, they expose budgets to any increase in policy rates and
abrupt changes in private market sentiment. Countries would be wise to heed the lessons
learned by Canada in the 1990s: the bond market is there until it is not.
Implications of low for long for the financial sector
The conviction that interest rates will be low for long can lead to various types of risky
behaviour in the financial sector.
As we have all just been reminded at great cost, an extended period of stability breeds
complacency among financial market participants as risk-taking adapts to the perceived new
equilibrium.7 Indeed, risk appears to be at its greatest when measures of it are at their
lowest. Low variability of inflation and output (reduces current financial value at risk and)
encourages greater risk-taking (on a forward value-at-risk basis). Investors stretch from liquid
to less-liquid markets and large asset-liability mismatches are stretched across credit and
currency markets.
These dynamics helped compress spreads and boost asset prices in the run-up to the crisis.
They also made financial institutions increasingly vulnerable to a sudden reduction in both
market and funding liquidity.8
The crisis prompted a brutal reversal, culminating in the panic in the autumn of 2008.
The period ahead will be somewhat different. In particular, perceptions of macroeconomic
risk are more volatile, which should help limit complacency.9 Nonetheless, some of the risky
dynamics associated with perceptions of an extended period of low interest rates could still
be at work going forward.
For example, over the past year and a half, banks have used low short-term funding rates to
rebuild capital by investing in long-term government bonds.10 This strategy is effective to a
point, provided complacency does not set in over the duration of low policy rates. Making
consistent positive carry may diminish the sense of urgency with which banks reduce
leverage or write down bad assets. Financial institutions may also take this game too far,
underestimating the risks. This is a particular concern since banks have considerably
shortened the term structure of their funding in the aftermath of the crisis. Banks would do
well to remember that marginal adjustments of interest rates have non-negligible effects
when leverage is high.
A prolonged period of low interest rates also has important implications for insurance
companies and pension funds with their longer-term guaranteed returns or benefits. By
reducing yields on assets and raising the net present value of liabilities, a sustained period of
low interest rates makes these guarantees harder to fulfill. To address potential shortfalls,
funds could move into riskier assets in a search for yield and/or shorten their duration to limit
asset-liability mismatches.11
The extent of these strategies will depend on accounting treatment of liabilities and
regulatory arrangements. Some new proposals such as the recent International Accounting
Standards Board's proposed amendments to accounting standards for insurance contracts
(IFRS 4) could have far-reaching systemic implications. The Bank correspondingly welcomes
the Chairman's recent decision to consider other options to improve the transparency and
international comparability of insurance accounting.
Implications for the corporate sector
Low rates for an extended period of time reduce the incentives for banks to enforce the terms
of loans and for firms themselves to adjust.
Past experience has shown that low policy rates allow "evergreening," or the rolling-over of
non-viable loans. The classic example was Japan in the 1990s when banks permitted
debtors to roll over loans on which they could afford the near zero interest payments but not
8
See M.K. Brunnermeier and L.H. Pedersen, "Market Liquidity and Funding Liquidity," Review of Financial
Studies, 2009 22(6):2201-2238.
9
An analysis of the factors driving the weekly rates of return on a wide range of assets suggests that, since the
bankruptcy of Lehman Brothers in September 2008, a higher proportion of the overall variation in weekly asset
returns can be explained by a common factor. See Bank of Canada, Financial System Review, December,
2010.
10
The expectations channel is important because it determines the term spread, net-interest margin
and forward-looking capitalization (accrual) of the banks. See T. Adrian and H.S. Shin, "Financial
Intermediaries, Financial Stability and Monetary Policy," a paper prepared for the symposium,
"Maintaining Stability in a Changing Financial System," Jackson Hole, Wyoming, August, 2008.
11
To some extent, insurance companies are sheltered from the immediate effects given the longer-term nature
of their obligations as well as penalties on the withdrawals of existing plans that can be sizeable.
BIS Review 170/2010
principal repayments. By evergreening loans instead of writing them off, banks preserved
their capital, but this delayed necessary restructuring of industry. Moreover, the presence of
non-viable (or "zombie") firms limited competition, reduced investment and prevented the
entry of new enterprises.12
Here in Canada, the risk of such delayed adjustment is relatively modest at present since
most Canadian corporate balance sheets are in outstanding shape. Corporate leverage
declined in the third quarter of 2010 - approaching its lowest level in two decades - and it
remains significantly below that in the United States, the United Kingdom and the euro area.
However, it is possible that a mild form of such behaviour could develop in some sectors
such as homebuilding, where land values may be slow to adjust to new realities. At present,
low carrying costs provide powerful incentives for developers to wait out the current softness.
Unfortunately, the best contemporary analogue to the Japanese zombie firms is probably the
U.S. household sector. Problems with the foreclosure process, government programs and
forbearance by lenders are all delaying the adjustments.13 Absent more aggressive
restructuring, the impact of negative equity on one-quarter of U.S. homeowners will weigh on
consumption for the foreseeable future.
Implications for households
Encouraged in part by low interest rates, Canadian household credit has expanded rapidly
during the recession and throughout the recovery. As a consequence, the proportion of
households with stretched financial positions has grown significantly.
In a series of analyses over the past year the Bank has found that Canadian households are
increasingly vulnerable to an adverse shock and that this vulnerability is rising more quickly
15
than had been previously anticipated.14,
While there are welcome signs of moderation in the pace of debt accumulation by
households, credit continues to grow faster than income. In some regions, lower house
prices have begun to weigh on personal net worth. Without a significant change in behaviour,
the proportion of households that would be susceptible to serious financial stress from an
adverse shock will continue to grow.
The Bank has conducted a partial stress-testing simulation to estimate the impact on
household balance sheets of a hypothetical labour market shock. The results suggest that
the rise in financial stress from a 3-percentage-point increase in the unemployment rate
would double the proportion of loans that are in arrears three months or more. Owing to the
declining affordability of housing and the increasingly stretched financial positions of
households, the probability of a negative shock to property prices has risen as well.
Even if the growth in debt continues to slow, the vulnerability of Canadian households is
unlikely to decline quickly given the outlook for subdued growth in income. In addition, private
consumption is unlikely to be bolstered by gains in house prices going forward.
Lines of defence
Experience suggests that prolonged periods of unusually low rates can cloud assessments of
financial risks, induce a search for yield, and delay balance-sheet adjustments. There are
several defences.
The first line of defence is built on the decisions of individuals, companies, banks and
governments.
The Bank's advice to Canadians has been consistent. We have weathered a severe crisis -
one that required extraordinary fiscal and monetary measures. Extraordinary measures are
only a means to an end. Ordinary times will eventually return and, with them, more normal
interest rates and costs of borrowing. It is the responsibility of households to ensure that in
the future, they can service the debts they take on today.
Similarly, financial institutions are responsible for ensuring that their clients can service their
debts.
More broadly, market participants should resist complacency and constantly reassess risks.
Low rates today do not necessarily mean low rates tomorrow. Risk reversals when they
happen can be fierce: the greater the complacency, the more brutal the reckoning.
The second line of defence is enhanced supervision of risk-taking activities. Stress testing in
major economies should focus on excessive maturity and currency mismatches, look for
evidence of forbearance (such as ailing industries receiving a disproportionate share of loans
or the loosening of standards for existing debtors) and analyse the impact of sharp moves in
yield curves.
These efforts will be aided by the imposition of the new Basel III regulations. Measures,
including a leverage ratio, new trading book rules and liquidity standards, will help curtail
excessive leverage and maturity transformation.
The third line of defence is the development of and selected use of macro-prudential
measures. In funding markets, the introduction of through-the-cycle margining can help
curtail liquidity cycles.16 In broader asset markets, counter-cyclical capital buffers can be
deployed to lean against excess credit creation. Importantly, following the agreement of G-20
leaders in Seoul, the Basel Committee endorsed the Canadian-led proposal for this
framework.17
In the housing market, the Canadian government has already taken important measures to
address household leverage. These include a more stringent qualifying test that requires all
borrowers to meet the standards for a 5-year fixed-rate mortgage as well as a reduction in
the maximum loan-to-value ratio of refinanced mortgages and a higher minimum down
payment on properties not occupied by the owner. In addition, the Bank of Canada's interest
rate increases reminded households of the interest rate risks they face. These measures are
beginning to have an impact.
Canadian authorities are co-operating closely and will continue to monitor the financial
situation of the household sector.
These defences should go a long way to mitigate the risk of financial excesses. But the
question remains whether there will still be cases where, in order to best achieve long-run
price stability, monetary policy should play a supporting role by taking pre-emptive actions
against building financial imbalances. As part of our research for the renewal of the
inflationcontrol agreement, the Bank is examining this issue. While the bar for further changes
remains high, the Bank has the responsibility to draw the appropriate lessons from the
experience of others who, in an environment of price stability, reaped financial disaster.
Conclusion
These are extraordinary times. A massive deleveraging has barely begun across the
industrialised world.
Canada entered this crisis extremely well-positioned. Due to the sacrifice of Canadians and
the foresight of successive governments, our public debt burden was the lowest in the G-7.
Thanks to the courage of my predecessors, monetary policy had tremendous credibility. Due
to the quality of public supervision and private risk management, our banks had one of the
soundest capital bases in the world. And after more than a decade of success, our corporate
balance sheets were in great shape.
By combining these strengths with decisive policy actions, we have managed well through
the turmoil. But the challenges we face have only just begun.
Cheap money is not a long-term growth strategy. Monetary policy will continue to be set to
achieve the inflation target. Our institutions should not be lulled into a false sense of security
by current low rates.
Households need to be prudent in their borrowing, recognising that over the life of a mortgage,
interest rates will often be much higher.
The weight of the adjustment beyond our shores means that demand for our products is
weak and competition fierce. We must improve our competitiveness. Recovery after a
recession demands that capital and labour be reallocated. The surge in business investment
that began this past summer can only be the start.
Now is not the time for complacency.
Thank you.