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By Kyle D'souza

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Welcome to my padlet wall. The topic that will be explained is on Canada's Monetary Policy. What you can expect to learn from this policy is the objective of monetary policy in Canada. Other things that will be discussed is how the Bank of Canada controls the inflation rate, and how the Bank of Canada influences interest rates.

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Monetary Policy entails implementing actions from the Bank of Canada to determine the economic activity within Canada. Two forces that impact monetary policy are the money supply and interest rates which are aimed to control inflation and regulate the growth and liquidity. For example, if Canada has a high unemployment rate, often resulting in a recession, the Bank of Canada can introduce an expansion policy which helps expand the economic activity.

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Monetary policy is concerned with how much money circulates in the economy, and what that money is worth.

What is the Bank's Approach to Monetary Policy?

The cornerstone of the Bank's monetary policy framework is its inflation-control system, the goal of which is to keep inflation near 2 per cent - the mid-point of a 1 to 3 per cent target range. This system provides a clear measure of the effectiveness of monetary policy, and increases the predictability of inflation.

The Bank is equally concerned with significant movements in the inflation rate, both above the 2 per cent mid-point and below it. When demand is strong, it can push the economy against the limits of its capacity to produce. This tends to raise inflation above the midpoint, so the Bank will raise interest rates to cool off the economy. When demand is weak, inflationary pressures are likely to ease. The Bank will then lower interest rates to stimulate the economy and absorb economic slack.

See The Output Gap for more information about the impact of demand and production on inflation.

How is Monetary Policy Carried Out?

The Bank carries out monetary policy by influencing short-term interest rates. It does this by raising and lowering the target for the overnight rate. (The "overnight rate" is the interest rate at which major financial institutions borrow and lend one-day (or overnight) funds among themselves.) In November 2000, the Bank introduced a system of eight "fixed" dates each year on which it announces whether or not it will change the target for the overnight rate.

Changes in the target for the overnight rate usually lead to changes in other interest rates, and so affect people's spending decisions. This, in turn, influences the level of demand for goods and services. When demand exceeds supply, prices will rise.

What are its Benefits?

Low, stable and predictable inflation is the best contribution that monetary policy can make to a productive, well-functioning economy. It allows Canadians to make spending and investment decisions with more confidence. This encourages longer-term investment in Canada's economy, and contributes to sustained job creation and greater productivity. This in turn leads to real improvements in our standard of living.

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Monetary policy is concerned with how much money circulates in the economy, and what that money is worth. The cornerstone of the Bank's monetary policy framework is its inflation-control system, the goal of which is to keep inflation near 2 per cent - the mid-point of a 1 to 3 per cent target range.

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Nominal Interest rate refers to an interest rate that does not take into consideration the inflation. A real interest rate adjusts for inflation giving the most accurate rate. The way you calculate the real interest rate is you take the nominal rate and you subtract it from the inflation rate. The real interest rate is the rate that lenders or people that invest receive to give them a better idea if their purchasing power is increasing or decreasing.

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Short term interest rates apply to all money lent out for a period of one year or less. Long term interest rates can be either higher or lower then short term rates depending on the term of the loan, inflation and economic growth.

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Banks are independent businesses and because of this they are entitled to set their own lending rates. Even though financial institutions can set their own rate the Bank of Canada determines if the rate will rise or decrease. This is because financial institutions borrow from the Bank of Canada and if the overnight or bank rates increase then the smaller banks will have to increase their rate to make up for the rates they borrowed money from the Bank of Canada.

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Mortgage rates raised by two of Canada’s big banks

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The nominal rate, in relation to banks, is used to determine the amount at which borrowers pay to use the lenders money (Usually banks to individuals, businesses, or other banks). If the nominal rate on a loan is 5% then borrowers can expect to pay $5 of interest for every $1000 loaned to them.

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When the overnight rate changes other interest rates with a short or long term maturity change as well. Whether the rate goes up or down will determine the cost of borrowing for a 1-day period being cheaper or more expensive. Because there is uncertainty in the global financial markets, the cost of raising funds for Canadian banks have increased, which is being passed on to borrowers from banks. The less creditworthy you are the higher premium rates will be given to you.

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Statement by Mark Carney, Governor of the Bank of Canada to the Standing Senate Committee on Banking, Trade and Commerce

Mr. Chairman, the sharp movement and wide swings in interest rate spreads that we have witnessed since the onset of the recent financial market turbulence have prompted many analysts to question whether monetary policy remains effective in controlling inflation. The short answer is yes. Allow me to take a few minutes to explain why this is the case.

The Bank of Canada's policy objective is a 2 per cent target for total consumer price inflation. The tool we use to achieve our policy objective is the overnight interest rate - the rate at which major financial institutions borrow and lend funds for one day, or "overnight," among themselves. We set a target for the overnight rate and can achieve that target through our ability, using our balance sheet, to supply overnight funds.

When the Bank of Canada changes its target for the overnight rate, it sets in motion a complex chain of consequences that first influences prices in financial markets, and then affects spending, production and employment and, ultimately, inflation. Economists call this chain of developments the transmission mechanism. My focus here is on the first link in that chain.

With a change in the overnight rate, other interest rates along the maturity spectrum tend to change. Intuitively, this makes sense. If the cost to borrow money for a 1-day period becomes cheaper or more expensive, and this change is expected to persist, the cost to borrow money for a 30-day period, a 90-day period, a 1-year period, et cetera, should also change. In addition, administered interest rates such as the prime lending rate, and the prices of many other financial assets, including the value of the Canadian dollar and equity prices, are affected.

Thus, all else being equal, a change in the overnight rate of interest which is expected to persist will influence the overall level of short- to longer-term interest rates, and the prices of many other financial assets. But typically, all else is not equal and the situation we face today, with a fundamental repricing of risk taking place, is a good example.

Interest rates on various financial obligations include a risk premium that reflects the creditworthiness of borrowers and the degree of liquidity of the financial instrument. Corporate bonds, whether issued by financial or non-financial firms, carry a rate of interest that incorporates both of these considerations. Lending institutions, such as banks, set their lending rates on the basis of their cost of funds and on the creditworthiness of their customers.

Risk premiums (or credit spreads, as they are often called) are market determined. Any widening or narrowing of risk premiums is not something monetary policy can influence. But monetary policy can, and does, take into account these movements in risk premiums by influencing the overall level of interest rates through changes in the target for the overnight rate of interest.

Let me give you an example using the circumstances we face today. Because of heightened uncertainty in global financial markets and widening risk premiums, the cost of raising funds has increased for Canadian banks. These higher costs are being passed on to corporate and household borrowers. Less creditworthy borrowers are also facing higher credit premiums in the rates at which they can borrow from banks. But this does not necessarily mean that the absolute cost of corporate and household borrowing has risen.

The reason is that the Bank of Canada can factor in these movements in risk premiums, or credit spreads, when setting the target for the overnight rate at a level that is judged to be appropriate for achieving our 2 per cent inflation target. Such judgment led the Bank to lower its target overnight rate by 150 basis points since last December.

In summary, Mr. Chairman, the key point I am trying to convey is the difference between interest rate spreads and the absolute level of interest rates. The former is determined in competitive financial markets. The latter is what monetary policy can and does effectively influence. Recent developments have not altered this fact.

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The Transmission Mechanism and the Effectiveness of Monetary Policy Actions

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Statement by Mark Carney, Governor of the Bank of Canada to the Standing Senate Committee on Banking, Trade and Commerce Mr. Chairman, the sharp movement and wide swings in interest rate spreads that we have witnessed since the onset of the recent financial market turbulence have prompted many analysts to question whether monetary policy remains […]

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The Bank of Canada approved the inflation-control target in 1991. This target of inflationary control is there to keep consumer price index inflation at a 2 percent midpoint, 1 to 3 being the target range. The inflation-control target benefit is there to hold steady the rate of future inflation. This then leads to individuals, businesses and government to bring non-inflationary growth to the Canadian economy.

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Definitions

Inflation-control target

The inflation-control target was adopted by the Bank and the Government of Canada in 1991 and has been renewed several times since then, most recently in October 2016 for the five years to the end of 2021. The target aims to keep total CPI inflation at the 2 per cent midpoint of a target range of 1 to 3 per cent over the medium term. The Bank raises or lowers its policy interest rate, as appropriate, in order to achieve the target typically within a horizon of six to eight quarters-the time that it usually takes for policy actions to work their way through the economy and have their full effect on inflation.

Inflation

A persistent rise over time in the average price of goods and services - in the "cost of living."

Consumer price index (total CPI)

The Consumer Price Index (CPI) is an indicator of changes in consumer prices experienced by Canadians. It is obtained by comparing, over time, the cost of a fixed basket of goods and services purchased by consumers.

The CPI is widely used as an indicator of the change in the general level of consumer prices or the rate of inflation. Since the purchasing power of money is affected by changes in prices, the CPI is useful to virtually all Canadians.

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Definitions Inflation-control target The inflation-control target was adopted by the Bank and the Government of Canada in 1991 and has been renewed several times since then, most recently in October 2016 for the five years to the end of 2021.

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This image shows the operating bank at which the bank rate and the overnight rate are determined. The overnight rate is the midpoint of the operating band which is half a percentage point wide.

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The bank rate is the rate the Bank of Canada   charges on loans to the major financial institutions in Canada. In this video, published in July, the Bank of Canada raised the benchmark for the overnight rate to 1.5%. The reason for this is because the inflation rate has been the highest ever in seven years. The article then goes on to discuss how the inflation rates are going to affect the Canadian trade with the United States (Canadian exports)

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Canada's Monetary Policy