Bank of Canada Primer Part 2, Monetary Policy
Bank of Canada Primer Part 2, Monetary Policy PDF View
August 26, 2021
Last month we opened up our discussion on the Bank of Canada with the following paragraph:
On July 14th, 2021 the Bank of Canada issued a press release that they had held their “target for the overnight rate at the effective lower bound of ¼ percent, with the Bank Rate at ½ percent and the deposit rate at ¼ percent .” They then went on to say that “this is reinforced and supplemented by the Bank’s quantitative easing (QE) program, which is being adjusted to a target pace of $2 billion per week.”
The goal of today’s article, is to follow up on last month’s introduction to the Bank of Canada, with a more detailed discussion on the first of their core functions: monetary policy.
Let’s first start by differentiating Monetary Policy with Fiscal Policy.
Fiscal Policy is “the use of government taxing and spending powers to manage the behaviour of the economy. Most fiscal policy is a balancing act between taxes, which tend to reduce economic activity, and spending, which tends to increase it”
Monetary Policy, as we discussed in the last article, is the goal of influencing the supply of money that circulates in our economy in order to keep inflation “low and stable.”
When we say “supply of money” we are referring to the amount of money that is in Canada’s economy as measured by such instruments as currency (paper money and coins), chequing accounts and savings account balances (held at banks, trust and mortgage loan companies, credit unions, and caisses populaires), and money market holdings (i.e. money market mutual funds).
Given this, the Bank of Canada’s objective when it comes to monetary policy is to “preserve the value of money by keeping inflation low, stable, and predictable.” They do this by maintaining an inflation-control target and through the operation of a flexible exchange rate.
Inflation Control Target
The bank of Canada sets an inflation target at 2% and has for some time. The bank then uses that target to set their policy interest rates (which they announce 8 times a year). This policy interest rate is also called the “target for the overnight rate.”
But how does setting interest rates manage inflation?
Well, when the Bank of Canada sets its policy rate, it affects how chartered banks (like RBC, TD, CIBC, etc.) and other institutions set their own borrowing rates. When the BOC sets its policy rate low, your bank will also set their lending rates low. This stimulates borrowing. When you choose to borrow, you have something you’re planning on spending that borrowed money on; things like houses, cars, renovations, etc. This activity puts money into the economy, and may serve to increase prices (i.e. inflation).
When an economy heats up, and inflation gets too high, the Bank of Canada will attempt to lower it by setting their policy interest rate higher. This will drive banks and other financial institutions to raise their borrowing rates. If borrowing rates get too high, people will slow down their borrowing. They may also look to invest their money in interest bearing securities like GICs and Bonds that will pay them these higher interest rates. This takes money out of the economy, thus slowing down the rate of growth in the prices of day to day goods in the economy; in other words lower inflation.
Let’s now jump back to our initial quote:
On July 14th, 2021 the Bank of Canada issued a press release that they had held their “target for the overnight rate at the effective lower bound of ¼ percent, with the Bank Rate at ½ percent and the deposit rate at ¼ percent.“ They then went on to say that “this is reinforced and supplemented by the Bank’s quantitative easing (QE) program, which is being adjusted to a target pace of $2 billion per week.”
The global financial system is very complex and interconnected. In Canada, institutions like our Canadian banks, on any given day, may have sent out more in payments than they have received, while others may have received more than they sent out. Since they must balance, financial institutions may borrow from each other for one day in the overnight market. Ideally, the Bank of Canada wants financial institutions to charge each other the overnight rate on those loans, but they don’t have to. They can also borrow from the Bank of Canada and receive the “bank rate” for one night. The Bank of Canada also gives them the option to deposit any excess amount at the Bank of Canada and receive the “deposit rate” for one night.
The difference between the deposit rate and bank rate (called the operating band) is historically ½ a percent; however, in this time of excessively low rates, it is only ¼ of a percent. Typically financial institutions borrow and lend with each other and don’t utilize the Bank of Canada, but the operating band that the Bank of Canada sets creates incentive for the banks to borrow and lend to each other within this range.
Quantitative Easing
Since the time of Covid-19, both interest rates and inflation have been so low that the Bank of Canada has been reluctant to lower interest rates further. For that reason, they have utilized another tool to try to stimulate the economy and raise inflation back to their target of 2%. That tool is called quantitative easing.
Before talking about what quantitative easing is, let’s consider the government for moment. Remember in our last article we discussed deficits and debts run by the federal government. The government needs to raise money to pay for these deficits. They do this by selling government bonds. Those bonds are sold to the public (facilitated by the Bank of Canada), through financial institutions and investment dealers in Canada and they are bought by banks, mutual funds, pension funds, insurance companies, etc. because of the interest they pay and the “almost” guarantee that the government will be able to pay the money back when the bonds mature at a later date.
Quantitative easing is a policy whereby the Bank of Canada buys up these government bonds directly from these financial institutions that own them. In payment for these bonds, the financial institutions get something called settlement balances (or reserves). This purchasing technique does a couple of things. First of all, it keeps demand for government bonds high. This keeps the price of the bonds high, which keeps the interest rate yields on the bonds low (it may even decrease them). Secondly, these new settlement balances/reserves allow the banks to lend out more money. With these low borrowing costs for households and businesses, comes increased spending, which heats up the economy, which should ultimately increase prices and thus move inflation back to the target of 2%.
Of course, if inflation gets above the 2% target, they can always reverse course as well, and sell government bonds back to the financial institutions they bought them from, which will have the opposite effect as the quantitative easing we just discussed.
Flexible Exchange Rate
As per the bank of Canada, the maintenance of flexible exchange rate permits them to “pursue an independent monetary policy that is best suited to Canada’s economic circumstances and is focused on achieving the inflation target.” Historically a drop in interest rates results in a weaker Canadian dollar. This makes goods we import from other countries more expensive; however, it makes goods we export to other countries cheaper for them so they buy more. On the other hand, when interest rates rise, so does the Canadian dollar. It has the opposite effect on imports and exports.
Monetary policy, although complex, is important to have some understanding of. Recent Bank of Canada consultations with the public (Click Here) indicated that Canadians are concerned about the future health of the economy, their personal finances, rising costs, job insecurity, and wealth inequality. The Bank of Canada uses this information to drive policy decisions that will have a significant impact on Canada and Canadians.
If you’d like to learn more about the Bank of Canada, you can also find a tremendous amount of information from the Bank of Canada Website (bankofcanada.ca), the primary source for this article.
If you’d like to discuss this topic further, please call us at (780) 426-2400, or e-mail us at LGKWealth@gmail.com to schedule an appointment.
[1] Fiscal Policy; The Canadian Encyclopedia; by Patrick Grady, February 7, 2006; Updated by Gord McIntosh, March 4, 2015; https://www.thecanadianencyclopedia.ca/en/article/fiscal-policy