Canada’s central bank finally acknowledged inflation is a monetary policy issue. Bank of Canada (BoC) governor Macklem dumped the transitory inflation narrative today. In a speech to Toronto’s CFA Society, he explained rising interest rates are just one monetary policy tool they’ll use going forward. The other is quantitative tightening (QT), a program designed to roll back an experimental tool that helped home prices soar. What the F- is QT, though?

Quantitative Ease

To understand QT, first  you need to understand quantitative ease (QE). QE is a non-conventional monetary tool used to increase inflation when rates are near zero. It involves the central bank buying government bonds on a competitive basis. Since they’re bidding up the price of bonds against investors, yields fall lower and lower. That’s the goal — the state tries to drive the cost of debt down, making it more attractive to borrow. Since credit markets are competitive, this lowers the cost of all borrowing.

Remember, the primary and only goal of QE is to increase inflation. It does this by making debt so cheap the public feels like a sucker for not borrowing money. By stimulating borrowing, they’re stimulating consumption, intentionally faster than supply can keep up. This helps to drive a non-productive increase in price, better known as inflation. In particular, corporate loans and mortgages are the segments they hope to stimulate. 

That’s right. Part of the goal is to drive more (and larger) mortgages, create demand for homes, and raise prices. The BoC even produced research showing low rates drive home prices higher. Just in case you were wondering if they understand this. Just so it’s crystal clear, this is how the BoC explained it to the industry in 2020:

“When the Bank buys government bonds of a given maturity, it bids up their price. This, in turn, lowers the rate of interest that the bond pays to its holders. When the interest rate on government bonds is lower, this transmits itself to other interest rates, such as those on mortgages and corporate loans.”

— Paul Beaudry, Deputy Governor Dec 20, 2020

To reiterate, in 2020 the BoC used QE to create higher inflation. It works by stimulating excess demand, non-productively increasing the price of goods. When it was clear inflation wasn’t transitory, they said it was supply chain problems. Finally, they’re addressing elevated inflation with monetary policy. No one knows where the inflation came from, after they spent billions per month on a program to create inflation. Supply issues, they said. Yeah, sure. Back to QT.

Quantitative Tightening: It’s Like QE, But In Reverse

Quantitative tightening (QT) is the opposite of the QE program and it lowers inflation. Instead of buying bonds to increase liquidity and lower yields, they do the opposite. The BoC said today they plan on executing this by not replacing the bonds as they mature. This will reduce the state-supplied liquidity for credit markets and increase bond yields.

The desired impact of QT is also the opposite of QE — to reduce inflation and purge monetary excess. Credit gradually tightens, and liquidity is reduced. This brings up the cost of borrowing, improving affordability after an adjustment period. It does this by slowing consumption, and thus price growth. Once again, the opposite of QE.

Over the next year, a combination of rising rates and QT will reverse elevated inflation. This is good news for everyone but real estate speculators, since it means a healthy economy. No longer is stimulus needed, things are humming on their own, and long term economic value is created.

Canada’s Big Six banks have been advocating for these kinds of moves for a year now. By acting early, they could have addressed the issue early on. Now they’re trying to use a tool never before used in Canada, to tame a 30% high for inflation and record home price growth.