Interest rates and gold

Nick Rowe recently asked what the point of repoing an object was when you could just sell it, repurchasing it later. He could see three reasons. Firstly, you might repo a particluar thing because you hold it dear and want it back. It might not be available were you to simply try buying it back. Secondly, you might repo an asset because future liquidity might be an issue. Thirdly, you might repo an asset rather than sell it because future prices are uncertain. My comment used gold markets as an analogy:

Nick, I think for financial assets you are right about points 2 and 3. In gold markets, for instance, you'd rather lend or swap (ie. repo) your gold than sell it (upon the anticipation of buying it back at some future point) because you might fear that, come time to buy the gold back, the future price could be much higher, or that the gold market could be illiquid and you might not be able to buy.

Incidentally, you can also sell your gold and buy a futures contract. Selling spot and buying a futures contract is financially equivalent to swapping (repoing) gold - in both transactions you'll lock in a guaranteed price and will avoid the risk of illiquidity. So your question: why repo? is similar to the question: should I sell some asset and simultaneously buy a futures contract or sell it and take the risk of buying back at spot at some future point in time.

Some people might recognize these various gold transactions. A gold swap — a temporary exchange of gold for cash — is transacted at the GOFO (gold forward) rate. A gold loan, which is an unsecured and temporary exchange of gold for nothing but a promise to repay, is transacted at the gold lease rate.

You can actually conceptualize both transactions as swaps. In the first, gold is temporarily swapped for a liquid and safe financial promise (cash). In the second, gold is temporarily swapped for an illiquid and safe financial promise (a promise to repay the gold ie. "paper gold"). Lingo-wise a swap is no more than a repo.

The different rates at which these two swaps are conducted — GOFO and the lease rate — will be determined by the relative subjective value gold owners place on the swapped-for assets. Because liquid financial promises provide more services to their holders than illiquid promises, anyone swapping away gold will prefer the former to the latter. That's why the gold lease rate — the rate paid by the person taking the gold to the person foregoing that gold - has always been higher than GOFO. After all, the party swapping away gold needs some increased financial incentive to take the illiquid "paper gold" asset rather than the liquid cash.

Indeed, liquid and safe financial assets are so valued, and so easily storable, that in general, anyone swapping away their gold will not receive a fee for foregoing the metal. Rather, they will pay a fee for the advantages of getting cash. This fee is what GOFO represents.

These ideas can be tough to conceptualize. A while ago I caught the folks at FT Alphaville mixing them up. For instance, the author maintained that a dearth of cash in markets now meant that

since their cash had become more valuable to the market than their gold, they could now make a return from lending cash against gold, as opposed to gold against cash.

The above comment implies that the gold swap rate — cash for gold, or GOFO rate — has somehow switched. But in actuality, those swapping away cash for someone else's gold always earn a return (GOFO). This is because they are foregoing liquidity. The gold lease rate has switched, but that is a different rate, and a different story altogether.

On the topic of gold, David Glasner asks why gold markets are rising due to hyperinflation fears but bond markets aren't:

Now my question — and it’s primarily directed to all those believers in the efficient market hypothesis out there — is how does one explain the apparently inconsistent expectations underlying the bond markets and the gold markets. Should there not be a profitable trading strategy out there that would enable one to arbitrage the inconsistent expectations of the gold markets and the bond markets?

I don't think there is any discordance to explain:

I think gold prices and bond prices have been rising over the last three years for similar reasons. In general, the economy-wide expected rate of return has been falling (towards zero, perhaps below it) as investors grow fearful of the future. This pushes people into safe bonds. It also pushes them into assets like gold that have very low storage costs, since buying some easily-storable durable asset and holding it over time provides a 0% return, better than most risky alternatives which are expected to fall.

So I don’t think there are segmented expectations in these two markets, nor do I think it is worthwhile trying to arbitrage them.

Returning to the discussion of GOFO, if today's gold markets were actually dominated by those who believed in the inevitability of hyperinflation rather than (fairly) rational actors, then GOFO would be inverted... in essence, anyone who swapped away their gold for cash would expect to receive the GOFO rate rather than pay it. The current practice, as I pointed out above, is to pay that rate, not receive it. The reason for the inversion would be because the destiny of cash in a hyperinflation is demonetization and, as a result, it will lose all of its liquidity premium, whereas gold's destiny is to be remonetized and gain a relative liquidity premium. As a result, any gold-for-cash swap based on a universal expectation of hyperinflation would require whoever foregoes the benefits of gold's inevitable superior liquidity to be compensated by a return. Needless to say, GOFO has not inverted. Those foregoing  their gold still pay up to those foregoing cash.

Is the Swiss National Bank really Chuck Norris?

I once got accused by Scott Sumner of having the silliest comment he had ever read back on this post. Recent events show that I wasn't being so silly.

Around that time, the Swiss National Bank (SNB) had announced a peg of 1.20 EUR/CHF. The argument going around the market monetarist blogs back then was that central banks were akin to Chuck Norris - they only needed to explicitly announce a target and that target would be effortlessly hit, just like how Chuck Norris can make a row of kung-fu masters fall like dominoes just by threatening to hit them.

I made a few other comments to the effect that a central bank has to build up credibility before anyone will accept it as Chuck Norris-like. Here is one comment:

On August 3, the SNB announced it would be purchasing CHF50b in assets to drive EUR/CHF up. Over the next five days it purchased this amount, but the CHF continued to strengthen. On the 10th the SNB announced it would be purchasing an additional CHF40b in assets, which it proceeded to purchase over the next five days. The CHF finally started to weaken. On the 17th, the SNB announced it would purchase another CHF80b in assets. The data shows that it executed this full amount by the end of the month.

EUR/CHF went from 1.02 on August 10 to 1.19 by August 28, so a lot of speculators were hurt. It fell back to 1.10 in the next four trading days, and then on September 6 the peg was announced. Presumably the announcement of the peg drove EUR/CHF back up to 1.20 but seems not have required as much effort, although I'd wait to see the SNB's next monthly bulletin to be sure.

The point of I was trying to make back then is that what made the 1.20 peg credible was the initial beating up by the SNB in August, so when it finally announced the peg, it didn't have much work to do. Had it not beat up long CHF specs in August, the target would have required an incredible amount of purchases to implement. A central bank that lacks credibility can't just announce and expect things to magically fall into place.

Fast forward to the present and something odd is happening. As the chart below shows, the SNB is buying up huge amounts of euros in order to defend the CHF peg.

According to the Chuck Norris theory of central banking, this shouldn't be happening. A central bank that announces an explicit target, as the SNB has done, shouldn't have to expend any effort to protect that peg. But SNB foreign currency holdings have increased from under CHF250b to over CHF350 in just two months.

The SNB shouldn't have to defend the peg because in promising to purchase infinite amounts of euro deposits at 1.2000 EUR/CHF, private European banks will in turn step in and purchase euro deposits with CHF 1.2000. That's because with the SNB backstopping 1.2000,  they know that they can't lose by purchasing all the euros offered at that rate. Indeed, other banks will be willing to purchase euros for CHF 1.2001, knowing that the first group of private banks will in turn step in at 1.2000 because the SNB in turn has committed to stepping in at 1.2000. In sum, by simply expressing a commitment to buy euro deposits at 1.2000, the SNB creates a self-fulfilling loop whereby others defend the peg on the SNB's behalf by buying all euros at some amount greater than 1.2000. That's Chuck Norris in action.

The fact that the SNB has been forced to purchase large amounts of euro deposits indicates that for some reason, private banks haven't been stepping in to do their part. As a result, the SNB has had to fill the gap they have vacated. This could be because the banks don't believe that the peg is credible. Or maybe the SNB was never Chuck Norris to begin with. If the SNB isn't, then why would the ECB or Fed be Chuck Norris-like?

Decoding Glasner on reflux, inside and outside money, and reflux

I had a few comments on a recent David Glasner post. Basically, I was trying to understand the way he reconciles various aspects of the monetary system, namely, inside and outside money, the arbitrage mechanism that links these two assets, and the price level.

David responded to me-

Inside money cannot trade at a discount relative to outside money because inside money is issued on the condition of its being convertible into outside money, so they always are exchangeable at par. If too much inside money is created (i.e., more than the public desires to hold given the relative attractiveness of holding inside money relative to alternatives including outside money) it refluxes back to the issuing banks. 

David says that excess inside money (say convertible bank notes) will reflux back to an issuing bank. But the only way this can happen, as far as I can see, is if somehow that bank's inside money trades at a slight discount to outside money (gold). David in his first sentence above says that inside money cannot trade at a discount. But how else can a reflux process emerge if one can't fall to a discount with the other?

So a temporary price discrepancy is necessary to enforce reflux and keep the quantity of outside money equal to demand. But what happens if inside money - say convertible bank notes - and outside money - fiat notes - are considered perfect substitutes by their users? After all, they can both be used to pay taxes, buy stuff, and "store value" over time.

David, for instance, points out that-

Because inside money and outside money are fairly close substitutes, the value of outside money is determined simultaneously in the markets for inside and outside money, just as the value of butter is determined simultaneously in the markets for butter and margarine. 

The problem here is... if inside and outside money are perfect substitutes, then given an excess issuance of convertible bank notes by a bank, why would the price discrepancy between inside and outside money that is necessary to drive reflux ever arise to begin with?

Rather, in an effort on the part of individuals and firms to rid themselves of their extra balances (either inside or outside money, they are indifferent) they will spend away both willy nilly. In spending away outside money, they will cause the price level to increase (the value of outside money to fall). David points this out:

If, however, the quantity of inside money increases because the public wants to hold the additional balances and are induced to hold inside money instead of outside money, then the value of outside money will tend to fall (causing the value of inside money to fall as well) unless the value of outside money is maintained by some form of convertibility or a price rule.

But doesn't this mean that issuing banks might cause infinite inflation by issuing inside money no one wants, thereby confirming Milton Friedman's wariness of free banking?

It would if currency users did in fact treat inside and outside money as equal.

But we live in a competitive banking system in which multiple banks issue inside money and receive other bank's inside money via cheque deposits and money transfers. Furthermore, currency users do not have uniform views about the quality of various money-like assets. Unlike individuals, competitive banks are picky and prefer to hold outside money rather than another bank's inside money. Put differently, banks are very sensitive to the store-of-value nature of inside money... they tend to view it as a financial asset characterized by risk and return, and not as a medium of exchange, and therefore view inside money as inferior to outside money due to its riskiness. Furthermore, holding another bank's inside money because they value its liquidity would be silly, since the bank already has its own liquidity factory. Thus the moment they receive another bank's inside money, a bank returns it to that issuer as fast as they can, settling with outside money. A reflux mechanism is thereby enforced by interbank settlement.

In sum, excess issuance of inside money by banks will not cause the price level to rise - it will cause the inside money to return to issuer.

The Interdistrict Settlement Account finally settles

Last year and earlier this year, debate concerning the Target2 mechanism in Europe and its growing imbalances shed some light on the equivalent institution in the US, the Interdistrict Settlement Account (ISA). The argument has been made to import the ISA structure into Europe, in particular, the yearly settling of accounts between district Reserve banks. If the ECB were to operate this way, the idea goes, then there would be some sort of quid pro quo on Target2 imbalances - European national central banks (NCBs) would not be able to accumulate debts to each other ad infinitum.

The observation was made that contrary to what one might expect, the ISA at the time did not seem to be balancing. Thus the idea that adoption of the Fed model would impose "firm limits" on intra-Eurosystem credit is invalid, since the Fed doesn't seem to always impose settlement on district Reserve banks. This April, though, the ISA seems to have been settled, as the charts below will illustrate. Nevertheless, the point still stands that the Federal Reserve System may choose to constrain itself by requiring interdistrict settlement or it may choose to forego that restraint.

Inflation as theft

Noah Smith writes a somewhat facile post targeting internet Austrians. They're too easy of a target - and I doubt that thinkers like Mises, Menger, or Hayek would disagree with any of Smith's facts and calculations.

They might disagree with the spirit of his post. His post paints a somewhat benign view of inflation. For instance, he pokes fun at the idea that inflation is akin to stealing by pointing out that a large component of the public (those with large debts) actually benefit from inflation.

The "inflation as stealing" meme is a very old one that predates Austrian thinkers, as I pointed out in my comment:

On a superficial level I agree with you.

On a deeper note, the idea that altering the value of money can be equated to stealing is a very old idea that predates Austrian economics, and in attacking Austrians you're also attacking thinkers like Adam Smith, ARJ Turgot, and Richard Cantillon who wrote along similar lines and were reacting to very real circumstances.

In medieval Europe, the sovereign was often the realm's biggest financial actor, controlled the mint, and by corollary set the definition of what constituted the unit of account. Debts were payable in these units. Prior to paying off its debts, the sovereign had a huge incentive to "cry up" the coin - reduce the amount of gold in the unit of account, thereby reducing the real amount the sovereign owed its creditors. On the other hand, when the sovereign was creditor and expecting payment, they had a huge incentive to "cry down" the coin, thereby increasing the amount of gold in the unit of account and increasing the real value of what they were to receive.

In short, there have been situations in which inflation and deflation "steal" the public's resources (the public being anyone who is not the sovereign). I would be hesitant to apply this to the modern western situation, but in analyzing the economics of modern third world dictatorships, it is important to understand how the dictator - much like a medieval king - might utilize the monetary system to redistribute resources from the public to his/her circle of cronies and thereby maintain a grip on power. I would strongly recommend most people from these sorts of nations to ignore your somewhat facile and euro-centric description of the effects of inflation and other forms of monetary confiscation, but I doubt they need my advice as they are probably more well-versed in the specifics than I.

In short, when the entity that is the largest debtor is also the entity that defines the nation's unit of account, and also controls the balance sheet of the nation's central bank, you have a significant conflict of interest. That doesn't mean that something conflicted will necessarily occur... but you might want to keep the potential for shenanigans in mind. In times past, conflicted sovereigns haven't always been hesitant to use their control over the monetary system to steal from non-sovereigns, and thus the meme "inflation is theft" has survived over the decades.


Here is Adam Smith, who in pointing out why the coin of the realm was below the original standard in weight, ascribed it to:

...the temporary and fraudulent views of the government, who found their interest at times to diminish the coin by adding a greater quantity of alloy, in order to pay off their various debts with a small quantity of silver and gold... in the 1st place, the creditors of the government are cheated of their money; if the coin be one half less they have but one half of the value that was given to the government, though they have in appearance the whole. To screen themselves also it is necessary that all debts in the kingdom should be paid by this money in the same manner as by the old money. So that all the creditors in the kingdom are in this manner defrauded of their just debts.

Two sources which are quite good on the method of augmentation and diminution of the coin of the realm. The first is from this chapter from Richard Cantillon's Essai sur la Nature du Commerce in Général, the second is excellent paper called Chronicle of a Deflation Unforetold by Francois Velde. The latter has another paper with Rolnick that describes the terminology of augmentation and diminution.


Here is a key for understanding the terminology:


Augmentation =  a way for the prince to reduce the real value of his debts owed by reducing the amount of gold in the nation's unit of account. An alternative way of thinking about this, the number of units of account that each coin could "purchase" was augmented.

Diminution =  a way for the prince to increase real income from debtors by increasing the amount of gold in the nation's unit of account

Debasement is a different term - it means to changing the physical constitution of the coin by reducing its gold content. The opposite of debasement is enhancement - adding precious metals to the coinage.  

W.H. Hutt (not Jabba)

David Glasner recently posted on the economist William Hutt and his book A Rehabilitation of Say's Law:

Hutt’s insight was to interpret Say’s Law differently from the way in which most previous writers, including Keynes, had interpreted it, by focusing on “supply failures” rather than “demand failures” as the cause of total output and income falling short of the full-employment level. Every failure of supply, in other words every failure to achieve market equilibrium, means that the total effective supply in that market is less than it would have been had the market cleared. So a failure of supply (a failure to reach the maximum output of a particular product or service, given the outputs of all other products and services) implies a restriction of demand, because all the factors engaged in producing the product whose effective supply is less than its market-clearing level are generating less demand for other products than if they were producing the market-clearing level of output for that product. Similarly, if workers don’t accept employment at market-clearing wages, their failure to supply involves a failure to demand other products. Thus, failures to supply can be cumulative, because any failure of supply induces corresponding failures of demand, which, unless there are further pricing adjustments to clear other affected markets, trigger further failures of demand. And clearly the price adjustments required to clear any given market will be greater when other markets are not clearing than when they are clearing.

North and South Euros

I had an interesting conversation with Miles Kimball at his blog concerning his idea of splitting the Euro into a North Euro zone and a South Euro zone. This seems like a far more realistic solution than reintroducing drachmas, punts, pesos, and lira. Nevertheless, there are some thorny issues here which Miles says he will address in future blog posts.

In short, a South Euro will quickly depreciate. Because wages are sticky, exports from the southern Euro zone will be relatively cheaper than exports elsewhere, providing a short to medium term boost to Greece, Italy, Spain, and Portugal.

One concern here is that the continued circulation of North Euros in South Euroland, as well as the North Euro's continued use as a unit of account in South Euroland, would make those living in South Euroland highly cognizant of nominal changes and therefore less likely to fall prey to the degree of money illusion that is necessary to drive an export-led recovery.

Of course, as Miles points out, his is a fourth best solution, so one should only nitpick so much, never mind the fact that it takes a solution to beat a solution, and I don't have one.

More on own-rates

The discussion on own-rates, the natural rate, and Sraffa cropped again.

Andrew Lainton blogged here, followed by Nick Rowe here, Daniel Kuehn here, and David Glasner here.

It seems to me that Nick and David are more or less on the same side of the aisle. I commented on Nick's post here, and Nick provided a helpful response. I commented on Glasner here, and he gave me some good feedback.

Bank of Canada watching - what's up with the balance sheet?

Normally this blog is just a comment aggregator, but once in a while I write a substantial post. Here’s one.

As a bit of a Bank of Canada watcher, I recently noticed that the Bank of Canada’s balance sheet is undergoing some interesting changes. Firstly, on the liability side of its balance sheet, government deposits held at the Bank have been growing quite quickly and are now at their highest level since the credit crisis. On the asset side of its balance sheet, BoC assets are growing at over 15% year over year after relative slow growth for the last few years.

Before exploring the reasons for these changes, as always I like to put the data into charts for context. As my first chart entitled North of 10% shows, BoC assets have only grown this fast a few times over the last few decades, mostly during crisis points like Y2K and 9/11. Giddy stuff.

click to zoom

The chart entitled Flight of the loon decomposes the growth of the BoC’s balance sheet into various components since 1981. If you look at the most recent twelve months, you’ll see what I mean about government deposits. Since last fall they have increased from under $1 billion to over $8 billion. On the asset side of the Bank’s balance sheet, this has been compensated by an increase in government bonds held by the Bank (the red bit).

click here to get a larger pdf version

All of this pales in comparison to what happened during late 2008 and early 2009, of course. This older period deserves a revisit. (The next ten paragraphs or so digress from the main topic – why the BoC’s balance sheet is growing now – so skip them if you wish). 

Begin digression.

In September 2008, as the Lehman crisis reverberated through the financial world, the Bank of Canada began to conduct large scale purchases of assets with Canadian private banks and other financial institutions.  The securities purchased were comprised of federal and provincial debt, Canada Mortgage Bonds issued by the Canadian Housing Trust, NHA MBS, as well as straight corporate bonds and asset backed commercial paper. These assets are represented by the gray section of the assets part of the above chart. 

In making these purchases the Bank of Canada was flooding the banking system with its own liabilities, otherwise known as clearing balances. The latter are accounts held at Bank by the commercial banks, and represent an obligation of the Bank of Canada. In our chart, these accounts are referred to as CPA deposits, where CPA refers to Canadian Payments Association. All large banks are members of the CPA and maintain clearing accounts at the Bank of Canada. This flood of balances would have threatened to send Canadian overnight lending rates plunging below their targets if they weren't simultaneously canceled out by equal and opposite transactions. This sort of central bank action is called “sterilization” in monetary economic lingo.

Looking at the chart, it is evident that the BoC sterilized their large scale purchases as there was no large increase in CPA deposits outstanding on the liability side of the Bank’s balance sheet, nor did overnight rates collapse. Instead, there was a large increase in government deposits. What happened here? Well, it’s not entirely clear. In all my Googling I haven’t found a single explanation by the Bank on how this was achieved. 

In this paper, Marc Lavoie and Mario Seccareccia describe the mechanism in this way:

During the first two weeks of October 2008, the Bank of Canada was selling the treasury bills that it held on its own balance sheet. The increase of term PRAs on the asset side of the balance sheet of the Bank of Canada were thus being compensated by a fall of an almost exactly equal amount of Treasury bills also on the asset side of the balance sheet of the Bank of Canada. In other words, the central bank was exchanging advances to the private sector in lieu of advances to the public sector. Thus, in this case and during the period going from July 2008 to mid October 2008, the size of the balance sheet of the Bank of Canada did not change by much.2

However, as happened with the Fed, from mid October on, the Bank of Canada started to follow a different approach in its efforts to provide more liquidity to term credit markets. From then on, the size of the balance sheet of the Bank of Canada grew very quickly, as the Bank was acquiring treasury bills newly issued by the Government of Canada, providing the Canadian government with deposits at the Bank in return. The acquired treasury bills were then sold in turn to the banks as a way to neutralize the effects of the liquidity-creating term repo operations. In so doing, the Bank managed to keep its stock of treasury bills at an approximately constant level, while the size of its balance sheet grew by the sum of the granted term advances and term PRAs.

If you just skipped through rather than reading the above comment, here is a brief summary. According to the authors, the Bank of Canada sterilized the large scale purchases by purchasing t-bills directly from the Federal government, then selling these bills to private financial institutions. In this way the excess clearing balances that had been created by the BoC’s large scale asset purchases were canceled as those balances were used by financial institutions to buy up t-bills from the Bank. Having directly bought fresh t-bills from the Federal government, the Bank of Canada now maintained a much larger deposit account on behalf of the Federal government. By not spending its deposits held at the Bank, the Federal government effectively kept these balances out of the financial system and ensured that the operation remained sterilized.

I’m not sure how much of the above is Lavoie and Seccareccia’s perception of events and how much is based on documented Bank of Canada descriptions of events. I haven't been able to confirm the former with the latter.

If we are going on hunches, I think the sterilization probably happened in a different manner. Private financial institutions began to buy up new t-bills issued by the Federal government in earnest beginning in September 2008 at the same time that the Bank of Canada began its large scale purchases. These t-bill purchases meant the government now held significant quantities of deposits in the private banking system. By transferring those deposits from the private banking system to the Bank of Canada, the Federal government could neutralize the effects of the BoC's large scale purchases. The excess quantity of clearing deposits created by the latter were effectively converted into government deposits, removing the excess. This is the old “drawdowns and redeposits" mechanism, nowadays referred to as the Receiver General cash balance auction. Through a twice daily auction, the RG determines what portion of the government's short term deposits should be allocated to the private banking system and what part should stay in the Bank, and the rate it will receive from private banks on those deposits.

Anyways, both Lavoie/Seccareccia route and mine lead to the final resting place. And both their mechanism and mine might have been simultaneously in effect, as well. But I still think the majority of the sterilization would have come from Receiver General auctions. Why? We know that the BoC’s asset purchases increased in size from zero to over $38 billion by the end of December. If Lavoie and Seccareccia are right that the sterilization of these purchases occured via BoC sales of t-bills, then it would have been necessary for the Bank to auction off some $38 billion in t-bills. But over that same time frame the Bank announced auctions worth only $15.8 billion worth of t-bills. Much of this would have been from its existing stock of t-bills. Because Lavoie and Seccareccia can’t account for the majority of t-bill sales that would be necessary to fully sterilize the $38 billion in large scale purchases, the only mechanism available to fill the gap are Receiver General auctions of government deposits. There may have been some direct purchases of t-bills from the government in order to resell them to the banking system, but not as much as the above authors seem to beleive. But I'm open to being convinced otherwise.

End digression.

Government deposits at the Bank of Canada have been rising over the last twelve months for much more banal reasons than crisis like Y2K or 9/11.

As part of the June 2011 Budget, the Government of Canada tabled a prudential liquidity management plan. This plan involved the government building up a $35 billion cash cushion to “safeguard its ability to meet payment obligations in situations where normal access to funding markets may be disrupted or delayed.” Of this $35 billion in extra liquidity, $10 billion was to be allocated to foreign reserves (primarily US dollar denominated), $20 billion to be held at the Bank of Canada, and another $5 billion to be deposited at private institutions (see pdf) 

The recent expansion in the Bank of Canada’s balance sheet is largely due to the debut of this prudential liquidity plan. Government deposits at the Bank, which spent most of 2011 between $1 and $2 billion, began to steadily rise last October and now clock in at $8.5 billion.

These deposits have been growing as a result of increased direct purchases of government debt by the Bank of Canada. Typically, the Bank buys a minimum percentage of the amount of bonds being auctioned in government debt auctions. On October 19, 2011, the Bank announced that it would be raising its allocation from 15% to 20%. As a result of its more aggressive purchasing commitment, Bank of Canada holdings of Government of Canada bonds have grown from $40 to $50 billion in just a few months.

By 2014, the amount of government deposits at the Bank should have increased to around $22 billion ($20 billion to satisfy the requirements of the prudential liquidity plan, and another $2 billion or so for normal operating balances). Bank of Canada assets, mostly government bonds, will have increased by that same amount.

A few scattered questions and comments before I sign off.

US readers will notice that for better or for worse, the Bank of Canada can do something the Fed cannot -  buy government debt directly from the executive branch of the government.

The Federal government evidently feels it needs to build up a cushion to safeguard its ability to meet obligations should funding markets freeze up. But if the Bank of Canada can simply increase the amount of government debt it purchases at auctions, one wonders why the government feels that it need ever worry about liquidity to begin with. I think the answer is somewhere along the lines of... markets don't mind if you monetize government debt in good times, it might be taken poorly during difficult times. So better to do it now.

At some point, the government may spend those deposits. Does the Bank have a plan in place to ensure that the government can spend them without influencing the overnight rate and therefore the ability of the Bank to target inflation? For instance, in a liquidity event in which the government has troubles issuing debt to the market, it will have to spend down its deposits at the Bank of Canada. But the Bank will have to simultaneously sell bonds in its portfolio in order to sterilize the government's spending. If it doesn't, there will be an excess position in LVTS and the overnight rate will fall below its target. How easily, both technically and politically, will it be to sell government bonds when they are less liquid than before?

Lastly, is the prudential liquidity plan really just a way for the government to lock in low interest rates? By selling low coupon debt to the BoC and holding it there interest free (all BoC profits flow back to the government), the government avoids the necessity of having to issue long term debt at potentially higher interest rates in the future. Do the BoC and Finance Department know something that we don’t – that they expect to be raising rates soon?