The Bank of Canada will continue to monitor wide credit spreads, it said today, as it continues on its mission to keep inflation low amid lasting financial stress.
“It’s very clear that these unusual spreads, and the financial market upheaval that exacerbated these spreads, will continue to have an impact for some time to come,” David Longworth, deputy governor of the central bank said in a speech in Lake Louise, Alberta today. “We do not know just when or how this turmoil will ultimately be resolved.”
He said that the “unusually” wide credit spreads globally relate, in part, to a rise of factors not related to credit risk, such as the drying up of market liquidity for investment grade corporate-issued debt. “Excessive pessimism” about expected default rates is another explanation, he added.
On the policy front, Longworth outlined three key areas: polices related to transparency and information; those regarding the regulation of financial institutions; and finally, central bank financial stability policies.
“We know that markets work best when relevant information is available to all,” he said, adding that transparency isn’t enough on its own, investors need to be able to interpret the information.
He did not lay blame on the ratings agencies and noted reputation will be a huge incentive for them to improve the content of their ratings. “This does not mean, though, that investors can rely exclusively on the judgment of others,” he added. “In the end, investors must accept responsibility for understanding and managing the credit risk in their portfolios.”
He also said banks need to readjust their risk management practices because they systems currently in place did not sufficiently prepare them for the recent market turbulence.
When it comes to central bank policy in turbulent times, Longworth told the Alberta audience that the bank is continuing to keep its eye on the real economy and the financial sector for their impact on inflation. While he said he does not want to downplay the financial turbulence of today, the bank aims “neither to favour particular market segments nor to insulate market participants from the consequences of their decisions.”
“As we work to better understand the forces behind these particularly wide credit spreads, we do realize that as difficult as it can be to price risk, the current situation demonstrates how much more difficult it is to price uncertainty,” said Longworth.
The Bank of Canada’s next interest rate announcement is scheduled for April 22.