The Bank’s Medium‐term Research Plan, 2019–21

Introduction

Leading-edge economic research and analysis are at the heart of policy-making at the Bank of Canada. Our research is most influential when it is innovative, timely and visible. As a result, key measures of the impact of our research are:

• the presentation of our research at leading conferences, and
• the publication of our research in top peer-reviewed journals.

Invitations to discuss papers at leading conferences and workshops are also an important form of recognition of our expertise.

Our people are our most important asset. Our team includes about 70 economists who spend most of their work time on research. Many others also make significant contributions. The Bank provides a strong research leadership team, career streams that focus on research and a vibrant mentoring program. Our researchers have regular access to top scholars, the latest tools and data and have sufficient time to conduct and promote priority research.

External partnerships are a key part of our research strategy. This includes sharing our data and collaborating with external co-authors. An example of a recent initiative is the Bank’s new Financial System Research Centre.

The 2019–21 research plan targets three high-level objectives:

1. advancing the frontiers of monetary policy,
2. better incorporating financial stability considerations into policy advice, and
3. ensuring sound and effective payment systems.

Several prominent themes transcend individual objectives. Some are of long-standing interest and include research on the design of the monetary policy framework, financial vulnerabilities and risks to the financial system. Themes related to the impact of new technologies also feature prominently. One is the economic implications of increased digitalization on the economy, productivity, inflation and labour markets. Another is how technology is transforming financial services including crypto assets and the potential for central bank digital currencies.

Building richer models that better capture changing economic conditions is one of the keys to success. To achieve this, we will explore new data sources as well as alternative approaches to economic modelling and new economic paradigms. For example, we will

• test the robustness of alternative monetary regimes within models with different degrees of rationality and forward-looking behaviour;
• expand our use of heterogeneous agent models to study the implications of high household indebtedness and the distributional consequences of unconventional monetary policies;
• make greater use of big data, machine learning and artificial intelligence; and
• explore new approaches, such as agent-based modelling—initial applications will focus on the interactions between different types of financial market participants.

Key advances in modelling coming from our research will be adapted for the Bank’s projection models.

The agenda

1. Advancing the frontiers of monetary policy

After almost a decade of subpar economic growth, the pace of economic activity has picked up. Monetary policy continues to support the recovery. While policy normalization is under way in some jurisdictions, the process has been gradual. Several risks to the outlook remain. In this context, it is crucial to keep in mind the lessons from the Global Financial Crisis (GFC) and ask how monetary policy can be improved.

Renewal of the monetary policy framework

The Bank formally reviews its monetary policy framework as well as the experiences of other central banks every five years. The next review is scheduled in 2021. As in past renewals, the Bank will carefully re-examine whether and to what extent the current regime has served us well and whether there may be better alternatives in the face of a continuously evolving economic landscape.

This round we will rethink how alternative frameworks should be assessed. In addition to the traditional objectives of price stability and macroeconomic stabilization, we will also consider other criteria to the extent that they can be clearly measured. For example, how well do frameworks deliver:

• good financial stability outcomes,
• the greatest good for the most number of people, and
• positive outcomes that are robust to competing views on the workings of the economy.

We will then revisit alternatives to inflation targeting, such as targeting the price level, average inflation or nominal GDP, or a dual mandate that incorporates some measure of real economic activity in addition to inflation. Our research will incorporate recent advancements in economic theory and re-examine the implications of some of the crucial assumptions made in previous work. Theories of non-rational expectations and global financial cycles as well as the predominant use of a few currencies for invoicing international transactions warrant closer attention.

There is special interest in how to best design and conduct monetary policy in a low interest rate environment. A lower neutral policy rate reduces the amount of conventional stimulus that the Bank can provide before hitting the effective lower bound (ELB). The experience since the GFC has led to a broad consensus that unconventional monetary policies (UMPs), such as quantitative easing and forward guidance, are useful. But what remains is the need to deepen our knowledge of their distributional and financial stability consequences. This will help us compare UMPs with alternative strategies to deal with the ELB, such as raising the inflation target or moving temporarily to targeting nominal GDP or the price level.

Another option is to explore complementarities of the monetary policy framework with fiscal and macroprudential policies, especially near the ELB. Open questions that will likely be carefully examined include the extent to which fiscal policy is effective as a countercyclical tool at different points of the cycle and whether automatic stabilizers or discretionary fiscal policy better complement monetary policy. Likewise, we will continue to explore the interdependence between the financial system and the economy at large, which has added financial stability implications to the forefront of framework issues.

Objectives

• Re-examine the efficiency of alternative monetary policy frameworks, such as targeting the price level, average inflation and nominal GDP.
• Evaluate the robustness of costs and benefits of alternative frameworks to uncertainty about the “true” economic model or the model’s parameters.
• Assess the importance of non-rational expectations for economic decisions of households and firms and the implications for monetary policy.
  • Key insights here may be considered for adoption in the projection models.
• Re-assess the level of the ELB in Canada, its implications for implementing monetary policy and for the financial system.
• Study the distributional and financial stability implications of the prolonged period of low interest rates and UMPs.
  • This research will inform development of main policy models to allow them to incorporate cross-country spillovers from UMPs and financial market frictions.
• Analyze the optimal mix between monetary, fiscal and macroprudential policies.
  • New and improved estimates of the fiscal multipliers and the impact of various macroprudential tools resulting from this work will be incorporated into the main policy models.
• Actively engage and collaborate with other central banks and academics to further our work on the monetary policy framework.

Improve our understanding of the Canadian economy in a shifting global economic landscape

Although economic activity in Canada has strengthened, a range of challenges remain over the medium term. Rising protectionism, a deterioration of international competitiveness, oil price swings, environmental issues and an aging population are among the most important. Against this background, it is crucial to be aware of their likely impacts and the options available for monetary policy. Furthermore, emerging-market economies play an increasingly important role in the global economy. We will continue to analyze growth and volatility in emerging-market economies and the spillovers to and from advanced economies.

We also need to take a deeper dive into how the transmission mechanism of monetary policy may be changing. For example, evidence shows that it is being affected by the level and composition of household and corporate debt. Heightened economic and policy uncertainty may also have an effect.

Objectives

• Evaluate economic challenges associated with protectionism, the decline in business dynamism and slow productivity growth, the aging population and environmental issues.
  • This work includes revisiting the modelling of trade in projection models. For example, the price elasticities of imports and exports in the Terms-of-Trade Model (ToTEM) will be re-assessed considering the evidence coming from the microdata.
• Analyze global trade and financial market linkages and their impact on monetary policy. This includes, for example, trade in services and international spillovers from quantitative easing.
• Study the implications of deeper integration of emerging-market economies into the global economy.
• Enhance our understanding of exchange rate dynamics, their linkage with commodity prices, and their implications for inflation and the real economy. This includes, for example, the effects of commodity price movements on exchange rates and the pass-through of exchange rate fluctuations to retail trade and inflation.
• Investigate how the level and composition of household and corporate debt and the characteristics of the financial sector affect the transmission mechanism of monetary policy and the normalization of interest rates.
• Analyze the impact of economic and policy uncertainty, including ambiguity aversion and imperfect information, on the decisions of households, firms and financial intermediaries as well as on the transmission of monetary policy.
• Analyze the interaction of trends in inflation and the neutral interest rate with the compensation for inflation risks and other risks in term structure modelling.

Explore the far-reaching implications of digitalization on the future of monetary policy and the Canadian economy

Digitalization, including innovations in artificial intelligence, robotics and other fields, is another key theme. Ultimately, these new technologies allow societies to do more with less, leading to improvements in the standard of living over time. Historically, new technologies have also tended to be net job creators over the long run, as labour is reallocated into areas that otherwise would have not been developed.

The introduction of new technologies, however, means that the type of skills that firms demand will change, which will result in significant difficulties for some workers. McKinsey estimates that, with current technology, at least 30 per cent of tasks are fully automatable in about 60 per cent of occupations in the United States.1 These are potentially big numbers—both in term of productivity enhancement as well as labour disruption. The fast-moving nature of digitalization requires ongoing research to learn how it will affect the economy and monetary policy.

Objectives

• Better understand how increased digitalization and automation may affect the Canadian labour market, productivity and the structure of the economy.
• Investigate the potential for digitalization to affect inflation.

2. Incorporating financial stability considerations in policy advice

A risk-management approach to monetary policy means that policy-makers need to consider not only the most likely future path for the economy but also the distribution of possible outcomes around that path. For example, the prolonged period of low interest rates in Canada has been accompanied by the rise of certain financial vulnerabilities: high household indebtedness and imbalances in the housing market. In other countries, UMPs have also been associated with a rise in financial vulnerabilities. The Bank is interested in how elevated vulnerabilities could affect the sensitivity of the economy and the financial system to adverse shocks as well as the transmission of monetary policy.

Policies have been introduced to limit the buildup of vulnerabilities. Assessing the effectiveness of these measures and their implications for monetary policy is an ongoing area of interest.

Financial market infrastructures (FMIs) play a key role in the financial system and overall economy. Research in this area will focus on the implication of the evolving economic structure, new financial regulation and new technology on FMIs.

Enhance the Bank’s assessment of financial system vulnerabilities and risks

A stable and efficient financial system is essential for sustained economic growth and rising living standards. The Bank introduced a risk‐assessment framework that aims to provide more discipline in identifying vulnerabilities in the Canadian financial system and more quantitative rigour in assessing the probability and severity of relevant risks to financial stability. Although progress has been made in developing and operationalizing this framework, some challenges remain.

Elevated household indebtedness, imbalances in the housing market and the potential for cyber attacks to disrupt the interconnected financial system remain key vulnerabilities affecting the Canadian financial system. Research will continue to focus on these and other potential vulnerabilities. We will also enhance the existing policy models and tools to help us better quantify the probability and severity of financial stability risks.

Objectives

• Exploit new microdata sets to analyze the composition and evolution of household and corporate indebtedness and imbalances in the housing market.
• Further enhance our financial system risk‐assessment models by
  • incorporating risks associated with foreign shocks,
  • including behavioural actions in the bank stress test model, and
  • mapping the interconnections within the Canadian financial system.
• Investigate vulnerabilities arising from the interconnectedness between economic sectors, financial infrastructures, markets and institutions. This will include studying new microdata on interconnectedness between the regulated and shadow banking sectors.
• Enhance our understanding of the mechanism through which liquidity and credit risks transmit financial shocks to the broader economy.
• Consider the use of new approaches, such as agent-based modelling, to deepen our grasp of the behavioural interactions between different types of market participants.

Evaluate the effectiveness of financial reforms and macroprudential tools

Since the financial crisis, sweeping reform of the global financial regulatory and supervisory framework has taken place. Key elements of the reform agenda included higher capital, liquidity and leverage standards. Furthermore, in response to elevated household indebtedness and imbalances in the housing market in Canada, several macroprudential housing finance measures have been implemented.

During the next three years, we will continue to evaluate the effectiveness of global reforms and macroprudential policy measures. We will study their implications for the efficiency and stability of the financial system by developing and leveraging state-of-the-art models and novel data sources. Namely, we will continue to develop macroeconomic models with banks to analyze the interactions between macroprudential and monetary policies.

Objectives

• Continue developing macroeconomic models with banks and defaults to inform and evaluate the regulation of the banking sector.
• Monitor and evaluate the effectiveness of financial regulatory reforms, and possible implications on the resiliency of the financial system.
• Deepen our understanding of the behaviour and 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.
• Study the effectiveness of alternative macroprudential housing policies and inform the design of new policy tools.

Assess the interaction between financial stability risks and monetary policy

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 hand, monetary policy can contribute to the buildup of financial imbalances, thus magnifying the economic consequences of future adverse shocks and increasing the probability and severity of future crises. Over this medium-term plan, we will continue to leverage new microdata sets and develop new policy models to assess the interaction between financial stability risks and monetary policy. Our aim is to better incorporate financial conditions and financial vulnerabilities in the assessment of risks to inflation.

Objectives

• Investigate how the level and composition of household and corporate debt and the characteristics of the financial sector influence the effectiveness of monetary policy.
• Continue to develop and use monetary policy heterogeneous agent models with household debt, housing and defaults to analyze the effectiveness of macroprudential housing policies and their implications for monetary policy.
• Evaluate the impact of fiscal, monetary and macroprudential policy changes on the distribution of expected GDP growth using the GDP-at-risk methodology.
• Study the optimal mix of monetary, macroprudential and fiscal policies, including their interactions and coordination.
• Improve our understanding of the financial system and monetary policy consequences of the Government of Canada’s current debt-management practices.

Ensure the integrity of financial market infrastructures and benchmarks

FMIs are at the heart of a country’s financial system. They facilitate the clearing, settlement 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 a major transformation caused by the growth of the international flow of goods and services, new financial regulations (e.g., the Principles for Financial Market Infrastructures [PFMIs]) and the ongoing innovation in digital technologies.

Objectives

• Study the potential role of central counterparty (CCP) clearing in the propagation of shocks and as a source of systemic risk.
• Exploit granular data (Canadian Depository for Securities/Canadian Derivatives Clearing Corporation) to analyze stress propagation in a network of exposures and the measurement and decomposition of systemic risk.
• Investigate improvements to CCP margin and loss-sharing rules.
• Analyze and develop a new Canadian-dollar term risk-free rate that could act alongside the Canadian Dollar Offered Rate as a complementary reference rate for the Canadian market.

Understand the major effects of fintech on the Bank and the financial system

One of the most visible aspects of the digitalization of the global economy is the rise of investment in financial technology (fintech). It was spurred, in part, by the potential use of distributed ledger technology (DLT), such as blockchain, to decentralize key aspects of financial intermediation. This happened together with the increasing use of big data techniques, such as machine and deep learning. These two trends—decentralization and the increased use of big data techniques—have begun transforming the financial services industry. Commercial banks, as well as central banks including the Bank of Canada, have begun experimenting with fintech, such as DLT, to help enhance their knowledge of these new technologies.

Objectives

• Develop proofs of concepts and pilot projects to explore the potential of fintech for various aspects of FMIs.
• Assess potential implications of DLT for the business models of financial intermediaries, financial stability and the transmission of monetary policy.
• Understand the use of artificial intelligence and machine learning in the financial sector and its implications for the efficiency and stability of the financial system.
• Explore how the industrial organization (ownership structure/platform competition) of fintech and financial intermediaries affect financial system efficiency and stability and inclusion.
• Use deep and machine learning to build models of financial participant behaviour.

3. Ensuring sound and effective payment systems

There has been rapid technological change in the field of electronic money and payments in recent years. The trend toward electronic payments will continue and likely accelerate. These developments have the potential to fundamentally change how we pay for goods and services, not only over the Internet but also in traditional point-of-sale transactions. New payment technologies have the potential to touch all the Bank’s core business areas: currency issuance, systemically important payment systems, financial stability and monetary policy.

Provide direction to and participate in the modernization of Canadian payment systems

One of the major drivers of these changes over this MTP will be the modernization of the core Canadian payment systems operated by Payments Canada. This involves

• replacing the Large Value Transfer System (LVTS) with a new wholesale payment system called Lynx,
• replacing the Automated Clearing and Settlement System (ACSS) with the Settlement Optimization Engine (SOE), and
• developing a new real-time small value settlement system called the Real-Time Rail (RTR).

Once these systems are largely in place, by the end of this MTP, Canadians will have access to a modern, fast and resilient payment ecosystem.

The objective of Bank research in this area is to better understand the economic trade-offs inherent in the new systems and their implications for the Canadian economy. More specifically, this research will help the Bank ensure that the new systems meet the guidelines for prominent and systemic payment systems and the needs of Canadians. It will also help the Bank develop the appropriate metrics for risk and efficiency in the various systems, both to help design the systems and monitor risk in the resulting operational systems.

Objectives

• Better understand the trade-off between liquidity and delay risk that participants in wholesale payment systems face.
• Develop models that help us study the effects of new payment systems on the Bank’s monetary policy implementation framework.
• Understand the impact that new retail and business-to-business payment systems can have on the efficiency of the Canadian economy.

Explore how and in what form the Bank could issue a central bank digital currency

The Bank of Canada is preparing for the possibility that electronic payments will replace physical cash. This includes deepening our grasp of the role of central bank liabilities in the economy and how the Bank could provide these in the form of a digital currency. Our work will extend beyond theoretical considerations as we aim to assess the circumstances under which the Bank of Canada should issue a digital currency and how this could be best done. The implications of this work are existential to the Bank of Canada, complex and important to the Canadian economy.

There could be significant consequences for existing systemically important payment systems, the regulation of these new payment schemes as well as the design of new payment systems. There could also be important implications for the functioning of traditional financial institutions, which could, in turn, have repercussions for financial stability.

Objectives

• Improve our understanding of the use of cash and assess the future trend of the demand for cash.
• Monitor the adoption and use of new payment technologies and private digital currencies, such as Bitcoin, and evaluate their implications.
• Study whether and how the Bank should issue a central bank digital currency (CBDC) and understand the implications of a CBDC on the Bank, the financial system and the economy.
  • This would include adjusting our main projection models to capture the macroeconomic impact of issuing a central bank digital currency.