Battling a Calamity: Monetary Policy and its Impact
by Mark Lovewell

The Effects of September 11th
The September 11th terrorist attacks had a deep impact on world politics. In addition to this political fallout, there were significant economic effects as well. In the weeks after the attacks, North America seemed headed for a full-fledged recession. Low investment had already caused an economic slowdown in both Canada and the US during the third quarter of 2001. The turmoil created by the attacks made it likely that US consumer spending would also weaken. This would have then led to a reduction in Canadian consumption, due to lower exports and incomes in the Canadian economy. Slumping stockmarkets in both countries further increased the chances of a North American recession, as household wealth in both countries fell along with share prices.
      The situation demanded a quick response by monetary authorities. The reactions of both the Federal Reserve (the US central bank, which is often simply called the Fed) and the Bank of Canada show how monetary policy can deal with sudden calamities.

Monetary Policy in both Countries
The Fed's policy decisions are publicized through changes in its target interest rate, known as the federal funds rate. This is the rate that deposit-takers in the US can borrow overnight funds from the Fed. The Fed's target federal fund rate is similar to the role of the Bank of Canada's target range for the overnight rate. Recall that Canada's bank rate is automatically set at the ceiling of the 50-basis-point range for the overnight rate. Since 2001, the Bank of Canada's public statements stress the target overnight rate, which is at the midpoint of the overnight rate's 50-basis-point range. This target overnight rate is therefore always a quarter of a percentage point below the bank rate.
      Both central banks now fix specific dates during the year when they make announcements relating to their target rates. On these dates (different for each bank), a decision is made either to change the relevant target rate or leave it untouched. Before September 11th, the Fed had already reduced its target federal funds rate by over 3 percent during 2001. It had done this to counteract the economic slowdown in the US caused by weak investment spending. At the same time, the Bank of Canada had also pursued a expansionary policy, with its target overnight rate falling by 1.75 percent.
      The events of September 11th meant that these interest rate reductions were now insufficient. The Fed and the Bank of Canada therefore reduced their target rates even more. In both countries, the relevant target rate was cut by the same percentage — 1.75 percent — before the end of 2001. In total, the target federal funds rate had been decreased from 6.5 to 2 percent during the year. Meanwhile, in Canada the target overnight rate had fallen almost as precipitously, from 5.75 to 2.25 percent.

A Monetary Policy Success?
Could these interest rate cuts by the Fed and the Bank of Canada counteract a deepening North American slowdown? Many economists in both countries were sceptical of the monetary policy's effectiveness in such extreme conditions. But the sceptics were proven wrong. During the fourth quarter of 2001, real GDP grew slightly in both countries, allowing both to skirt a formal recession, which is defined as two consecutive quarters of negative growth in real GDP.
      How did the North American economy stabilize? Investment spending was not significantly affected by lower interest rates, and continued to be fairly weak in both US and Canada. Stockmarkets too reacted cautiously to lower interest rates. But household spending in both countries was stimulated by cheap borrowing costs. Not only consumption of durable items was encouraged; spending on residential real estate in both the US and Canada boomed. Lower interest rates in the US and Canada prompted higher housing demand, as well as higher housing prices, which raised homeowners' wealth. This expansion of wealth cushioned the effect of low stockmarket prices, and helped prop up consumer spending in both countries. Thanks to the North American consumer — and the large proportion of their wealth in the form of real estate — the risk of recession had been averted.
      What does this experience tell us about monetary policy and its effectiveness? First, it suggests that monetary authorities can react swiftly to an economic shock caused by a sudden calamity. Second, it shows that the response by households to interest rate changes is more dependable than the response of businesses. It was consumption spending, as well as residential construction, that reacted most strongly to the drop in interest rates during 2001. When analyzing the potential effects of their actions on the economy, therefore, central banks should never forget the importance of individual households and their spending behaviour.

If directed to do so by your instructor, the following questions can be answered online and emailed to him/her or yourself.

1		If the Bank of Canada had not dropped its target overnight rate when the Fed was reducing its target federal funds rate in the last part of 2001, what would have been the likely economic effects in Canada, on the foreign exchange rate and net exports, as well as on the equilibrium price level and real output? What does this tell us about the freedom of the Bank of Canada to set its own monetary policy?
2		Access the Bank of Canada's website (at http://www.bankofcanada.ca) and the website of the Federal Reserve (at http://www.federalreserve.gov) to find out which days during the current year the Bank of Canada has set aside for announcements on possible changes to its target range for the overnight rate. Can you think of any reason why the announcement dates are different in the two countries?