David Longworth

Foreign exchange market efficiency tests: Implications of recent empirical findings

Abstract The recent empirical literature on the efficiency of the foreign exchange market has been characterized by strikingly contradictory conclusions drawn from similar empirical evidence. These contradictions result because (1) different maintained hypotheses are held and (2) different criteria ( e.g. , micro- versus macroeconomic) are used to judge the evidence. In this survey we organize the empirical literature under several headings: the presence of risk premiums, empirical regularities in regression tests, profitable trading rules, and advanced econometric techniques. In integrating this material, we consider the implications of the current evidence for investors, forecasters, policy-makers, and theorists.

Macroeconomic models and policy making at the bank of canada

Abstract Operating in a flexible exchange rate regime, and managed by professional economists with a long experience within the institution, the Bank of Canada is one central bank where model-based projections play a central role in shaping and informing the internal deliberations about the formulation and conduct of monetary policy. As a result, the needs of policy-makers are a foremost consideration for staff that develop and use models. This paper describes the trends in policy formulation and model development at the Bank of Canada over the last 25 years, emphasizing the interactions between them, and explains the move away from large-scale disaggregated models towards a smaller, more focused model that can be used for both policy analysis and economic projections.

The Canadian Experience with Weighted Monetary Aggregates

This paper compares the empirical performance of Canadian weighted monetary aggregates (in particular, Fisher ideal aggregates) with the current summation aggregates, for their information content and forecasting performance in terms of prices, real output and nominal spending for the period 1971Q1 to 1989Q3. The properties of money-demand equations for these aggregates, particularly their temporal stability, are also examined. The major aggregates considered are M1, M2, M3, M2+, and their Fisher ideal counterparts. Also considered are M3+ (which adds near-bank deposits to M3) and two liquidity aggregates, as well as their Fisher ideal counterparts. Over all, on the basis of the in-sample fit of indicator models, the out-of-sample forecasts by indicator models, the specification of money-demand functions, and the temporal stability of money-demand functions, Canadian simple-sum monetary aggregates appear to be empirically superior to Fisher ideal aggregates. Specifically, broad monetary aggregates are generally the best in predicting inflation, M1 works well in predicting nominal spending, and real M1 is the best predictor of real output. These conclusions generally agree with earlier studies, which have shown that weighted monetary aggregates rarely do better than simple-sum aggregates in predicting major Canadian macroeconomic variables.

Securing Monetary and Financial Stability: Why Canada Needs a Macroprudential Policy Framework

Canada’s inflation-target agreement between the government and the Bank of Canada is up for renewal by 31 December 2016. In the aftermath of the 2008-2009 global financial crisis, one of the critical issues for consideration is the integration of price and financial stability in the conduct of policy. This Commentary addresses the importance for the conduct of monetary policy of having a separate coherent framework for macroprudential policy – designed to prevent the build-up of systemic, or system-wide, financial risks. A key lesson of the financial crisis was the insufficient attention being paid to these risks and their consequences for the economy. The importance of this issue can be seen in two ways. The first relates to the interactions between monetary and macroprudential policy tools in light of concerns about rising levels of household debt. At various times, there will be situations when only one policy tool is needed, when both policies need to be used in the same direction, or when the two policies need to work in opposite directions. The second relates to the Bank’s current “risk management approach” to monetary policy. In the absence of a government framework for the active use of macroprudential tools, this approach implies that monetary policy becomes a more important line of defence against systemic risks than it needs to be, with the risk of sub-optimal monetary policy outcomes. Our conclusions are threefold: • Canada’s 2 percent inflation target and policy framework has served the economy well, most importantly in anchoring inflation expectations; • over the past two years, Canadian monetary policy would have been better placed to combat low inflation and excess capacity had macroprudential policies been openly geared to reducing the systemic risks associated with rising household indebtedness and housing prices; and • drawing on best practices, the government needs to elevate macroprudential policies by establishing clear objectives, tools and lines of responsibility and accountability. The payoff for Canadians cannot be overstated: greater assurance of both financial stability, as a result of assigned responsibility for macroprudential policy, and monetary stability, as a result of the Bank of Canada’s continued primary focus on inflation and output stabilization.

Combatting the Dangers Lurking in the Shadows: The Macroprudential Regulation of Shadow Banking

Since the 2008/09 financial crisis, the international regulatory community has taken steps to reduce the probability of future significant financial instability. So far, the emphasis has been on tougher capital and liquidity regulations for banks and greater transparency for financial products, and greater regulation of financial infrastructure such as central counterparties, trade repositories, and the clearing of over-the-counter derivatives. To mitigate the risks of another run on the shadow banking system greatly amplifying financial instability, some shadow banking entities ought to be regulated as banks or in a similar fashion to banks (for example, with capital and liquidity requirements) while in other cases regulation should cover banks’ relationships with them, their procyclical behaviour in certain markets (such as those for repos), or the ratings process for securitized products. Because of the diversity of the various parts of the shadow banking system, the policy responses proposed in this study differ significantly across those parts. Taken together, the implementation of these policies should help reduce systemic risk and the probability of future periods of financial stress, for a stronger and more stable financial system.

Exchange market efficiency: An examination of speculation across forward markets☆

Abstract The rejection of the joint hypothesis of exchange market efficiency and no risk premium is shown to hold up all across the term structure of forward rates for the Canadian dollar/U.S. dollar exchange rate.

Exchange rates and ‘news’: A comment

Abstract Although in a world with more than two countries the error term in standard exchange market efficiency tests will be correlated across exchange rates, such information cannot be exploited in tests of market efficiency since the relevant information variables are the same in all equations and thus seemingly unrelated regression estimates are the same as ordinary least squares estimates.

Debt and credit: Recent Canadian developments

Abstract In our examination of how recent developments (to 1988) in debt and credit markets have affected the Canadian economy, we compare the recent experience of borrower behavior in Canada with that in the United States, looking at debt-GDP ratios for various sectors and the corporate debt-equity ratio. In the late 1980s, the key differences between the two countries in the financial behavior of both the household and corporate sectors derive, we believe, from the sharper shock faced by Canadians in the early 1980s. Our examination of the relationship between credit growth and the growth of spending in the Canadian economy utilizes credit-indicator models developed at the Bank of Canada. We find that over the 1980–1987 period forecasts of the growth of real GDP and nominal GDP based on indicator models using real total household credit and nominal consumer credit, respectively, have narrowly outperformed the best bivariate monetary indicator models.

The profitability of forward currency speculation by central banks: A comment

Abstract The article by Beenstock and Dadashi (1986), which tries to examine the profitability of the forward currency operations of the Canadian Exchange Fund Account, is misleading in two ways. First, its longer sample period mixes forward contracts entered into during a fixed exchange rate period (contracts which proved unprofitable) with contracts from the flexible exchange rate period. Second, it assumes that the net forward position reflects entirely forward contracts and not ‘overnight’ spot transactions. Official reports and econometric evidence show that the latter transactions predominated.

A model of the Canadian global exchange rate: A test of the 1970s

Abstract This comment points out some methodological weaknesses in the Canadian global exchange rate model and the associated efficiency tests of Marwah and Bodkin. The model is found to be inadequate for policy analysis.