Fed normalisation could have ‘significant impact' north of the border, Canada deputy warns

In the event that US monetary policy normalisation "does not play out smoothly," the impact on the country's main trading partner "could be significant", Bank of Canada deputy governor Timothy Lane warned yesterday.

His comments came only hours before Simon Potter, executive vice-president of the Federal Reserve Bank of New York – the institution that implements the Fed's policies – took to Tokyo earlier today to outline how the US central bank intends to exit the most accommodative phase in the institution's history.

"The normalisation of US monetary policy will act to tighten Canadian monetary and financial conditions," Lane told a university audience in Ottawa. "Unwinding unconventional policies will tend to push up market interest rates in Canada and dampen the US expansion. This effect would only be partly offset by the downward pressure the exit would put on the value of the Canadian dollar".

Charles Evans, the president of the Federal Reserve Bank of Chicago, spoke on a similar theme yesterday, telling an audience in St Louis the Fed needed to be "patient about when we first increase the federal funds rate".

"The biggest risk we face today is prematurely engineering restrictive monetary conditions," Evans cautioned. "In this scenario, the FOMC [Federal Open Market Committee] could misjudge the presence and magnitude of economic impediments and misread the recent progress we have made as evidence of sounder economic trends."

The FOMC has indicated it will likely end its monthly asset purchase programme next month, meaning the central bank's balance sheet would peak at $4.2 trillion.

Once it begins normalising policy it will do so by removing excess reserves from the financial system, in order to gain better control over short-term interest rates. The New York Fed is currently test-running an overnight reverse repo facility that will be used specifically for that purpose.

"Conducting [reverse repo purchases] for same-day settlement with a broad range of counterparties – including primary dealers, money funds, government-sponsored enterprises and banks – allows the Federal Reserve to provide a safe, liquid investment to a wider range of money market participants than those able to earn [interest on excess reserves], and thus expands the universe of counterparties that should generally be unwilling to lend at rates below those available through the Federal Reserve," Potter explained in Tokyo.