Canada's lower neutral rate may encourage risk-taking: central bank

OTTAWA (Reuters) - Canada’s lower neutral interest rate reduces the amount of monetary stimulus that the Bank of Canada can provide and may encourage excessive risk-taking, the central bank said on Thursday.

A sign is pictured outside the Bank of Canada building in Ottawa, Ontario, Canada, May 23, 2017. REUTERS/Chris Wattie

The bank in April lowered its estimate of the neutral rate, at which the economy can work at full capacity with stable inflation, to between 2.5 percent and 3.5 percent, down from a range of 3 percent to 4 percent in 2014.

“This could pose some challenges for conducting monetary policy and ensuring financial stability,” the bank said in a research paper.

Besides monetary policy implications, the lower neutral rate could encourage excessive risk-taking.

“A low interest rate environment may increase the incentives for banks and other financial institutions to take on more risks ... (or) necessitate a shift into higher-yielding, riskier instruments,” the bank said.

A life insurer, for example, might do so because it could not meet its obligations by investing in government bonds or other highly rated assets.

The lower neutral rate also reduces the amount of conventional stimulus, typically interest rate reductions, that the bank can provide without hitting the effective lower bound, the bottom for its interest rate. As a result, it would be more likely that the benchmark interest rate, or policy rate, would be constrained by the ELB, estimated at -0.5 percent, the bank said.

The neutral rate is considered the anchor for the central bank’s policy rate. The Bank of Canada has hiked rates twice in recent months to return borrowing costs to more normal levels from near-record lows.

The lower neutral rate suggests that when this happens, the policy rate will probably converge to lower levels than those seen before the financial crisis.

The bank said estimates of the global neutral rate were falling steadily over the past few decades, in part because of an aging population and a worldwide pattern of higher savings and lower investment.

Reporting by Andrea Hopkins; Editing by Lisa Von Ahn