This series will provide an in-depth investigation into the Bank of Canada’s mandate, and it’s effects on Canada’s monetary policy over the decades.
What’s important to note, is that some of the terminology will definitely remain alien to those outside of the financial community, however we will take steps in addressing and simplifying the concepts in a manner more understandable for the reader, while at the same time holding true to its original context.
An outstanding account of the Bank of Canada’s monetary policy was created by the Bank of Canada in 1996 in a document titled: Bank of Canada: The Transmission of Monetary Policy in Canada. This document contains 10 papers
The introduction in the document notes that this document has been the first time researchers at the Bank have gathered together various stages of the transmission mechanism, in order to make the subject matter more accessible.
The focus of the papers tends to be on the early part of this transmission mechanism – that is, on the path between the actions of the Bank of Canada and financial market outcomes, since this is less researched and less widely understood than the links between financial market outcomes and spending and inflation.
Thus, as you will see below, all 10 of the research papers focus on the Bank of Canada’s actions .
The first paper in the volume has former Bank of Canada Governor Gordon Thiessen describing all the stages in the transmission mechanism, with an emphasis on the uncertainty at each stage, and on the initiatives taken by the Bank to lessen this uncertainty by increasing the transparency of its objectives and the way it implements policy.
The other papers in the volume are as follows:
- The implementation of monetary policy in Canada: (Pg 19) Bruce Montador – Paper provides an overview of the various monetary instruments through which the Bank of Canada implements monetary policy
- Bank of Canada cash management: main techniques for implementing monetary policy: (Pg 35) Kevin Clinton – The paper provides more detailed discussions of the monetary instruments than the paper by Montador
- Buy-back techniques in the conduct of monetary policy: (Pg 51) Kevin Clinton and Kevin Fettig – This paper also provides additional insight into discussions on monetary instruments as well
- From monetary policy instruments to administered interests rates: the transmission mechanism in Canada – a Summary: ( Pg 61) Kevin Clinton, Donna Howard – This paper examines the effect of eliminating the reserve requirements between the one day interest rate (Over which the Bank has the most influence) and other rates of interest
- The use of indicators and of the monetary conditions index (MCI) in Canada: (Pg 67) Charles Freedman – This paper sets out the rationale for use of the montary conditions index (MCI)
- The role of monetary conditions and the monetary conditions index in the conduct of policy: (Pg 81) Charles Freedman – This paper analyses the way in which strategic and tactical elements enter into the Bank’s decisions regarding the MCI path
- Empirical evidence on the strength of the monetary transmission mechanism in Canada: an aggregate approach: (Pg 87) Pierre Duguay – This paper has an assessment of the empirical evidence on the links from (interest rates and exchange rates) to total spending in Canada, and from (total spending and the exchange rate) to inflation.
- The role of economic projections in Canadian monetary policy formulation: (Pg 109) Pierre Duguay, Stephen Poloz – This paper shows the authors discussing the role of economic projections in the formulation of Canadian monetary policy
- Bank of Canada operations in financial markets: (Pg 121) Tim Noel – This paper describes some important changes that the Bank of Canada has recently made, in the way it implements monetary policy and intervenes in financial markets
Gordon Thiessen’s Paper
In Thiessen’s paper: Uncertainty and the transmission of monetary policy in Canada (Pg 5) Thiessen provides a focus on the inter-relationships of uncertainty and the transmission of monetary policy to the economy.
The questions he addresses are:
How do the various types of uncertainty influence the behaviour of economic actors?
And how does uncertainty affect the transmission of monetary policy through the economy?
First Thiessen outlines the Bank of Canada’s view of the transmission mechanism, paying considerable attention to the role of uncertainty. Next, he explains the various ways in which the bank has reduced that uncertainty
General Public and Market Uncertainties
There are various kinds of uncertainties that affect the economy and on the policy process.
1) One unvertainty arises because of the possible occurrence of events that are largely unexpected such as an economic shock. These events can be international or domestic in origin. An example given, was the rise of U.S. long-term interest rates through the first half of 1994. Another type of shock can be event(s) that are certain to occur, but whose precise nature or outcome is not yet known, and an example of this would be the budget, or the upcoming referendum in Quebec
2) Another type of uncertainty arises because the private sector may be unsure about the longer-run objectives of economic policies.
This chart summarizes both kinds of uncertainties quite this well.
Each number (the pink coloured line) in the diagram corresponds with a different aspect of the transmission mechanism and leads one to think of the following questions.
1. Term Structure. How do the Bank’s changes in the target overnight interest rate lead to changes in longer-term interest rates? Are the changes always in the same direction? What magnitude of changes are observed for longer-term interest rates?
2. Foreign Exchange Market. How do the Bank’s changes in the target overnight interest rate lead to changes in the exchange rate? How big a change in the exchange rate typically follows a change in the policy rate by the Bank of Canada?
3. Interest Sensitivity of Spending. How much, and over what time frame, do aggregate consumption and investment respond to changes in longer-term interest rates? Do different components of consumption and investment have different responses to changes in interest rates?
4. Sensitivity of Net Exports. How much do exports respond to a change in the exchange rate, and with what time lags? How quickly and in what magnitude do imports respond to the same change in the exchange rate?
5. The Multiplier. How big is the “multiplier” that connects initial changes in aggregate demand to the overall change in aggregate output? Over what time period are the full effects on aggregate output observed?
6. Excess Demand or Supply. How quickly does the excess demand or supply associated with any given output gap cause changes in the growth rate of wages and the prices of other inputs? How quickly do these changes show up in inflation?
Eight examples of the second type of uncertainty are shown with the yellow starbursts each referring to a different kind of shock that can affect the economy. A brief description of each is as follows:
A. Portfolio adjustments. For several reasons, creditors may decide to adjust their holdings of short-term and long-term Canadian securities, leading to changes in Canadian interest rates.
B. Foreign exchange market. Changes in exchange rates occur daily and for many reasons, including changes in the growth of the global economy, changes in world commodity prices, and changes in international asset portfolios.
C. Consumption and investment. Households change their spending, and firms change their investment plans, often in unpredictable ways. Expectations regarding future economic conditions are important.
D. Government expenditures. Canadian governments (federal, provincial, territorial, and municipal) change their spending on an annual basis, sometimes in unexpected ways.
E. Net exports. Changes in foreign income lead to changes in the demand for Canadian exports. The rise of specific countries in the production of certain goods frequently leads to changes in world demand, either away from or towards Canadian goods.
F. Potential output. The economy’s production capacity is not directly observable, and therefore must be estimated. Its growth depends on labour-force growth, the accumulation of physical and human capital, and the growth of productivity. Changes in potential output often cannot be detected until well after the fact.
G. Inflation expectations. Large and sudden changes in the prices of specific products frequently lead to changes in inflation expectations. However, the central bank’s commitment and credibility help to anchor expectations in the face of such shocks.
H. Inflation shocks. The rate of inflation is regularly affected by changes in indirect taxes, sharp changes in the prices of specific products, and by changes in the exchange rate that alter the Canadian-dollar prices of imported products. Not every change in measured inflation is caused by excess demand or supply in the Canadian economy.6
To summarize, the central bank could try to reduce the uncertainty of the public and of financial markets about its responses to the various shocks.
It can achieve this by:
A) Making clear the longer-run goal of monetary policy
B) Making clear the shorter-term operational targets at which it is aiming in taking policy actions, and its own interpretation of economic developments
Thus, by central banks remaining committed to a longer-term goal and sticking with it, as well as by lessening uncertainty about its own responses to shocks, the central bank had aimed to lessen the effect of the shocks on private sector behaviour.
In a nutshell, this means the Bank of Canada reduced uncertainties for the financial markets so that they would not react in chaotic, and volatile ways but would rather remain calm. The market, naturally would like to reduce risk as much as possible, and the Bank of Canada has been assisting in order to reduce this risk.
This notion of reducing risk and volatility in the markets will become much more important later in this series so please keep this in mind.
The instrument that the central bank has at its disposal in taking monetary policy actions is its control over the issuance of a crucial financial asset – typically referred to in the economics literature as “base money”
This base money, is usually composed of bank notes that are issued by the central bank, as well as deposits at the central bank held by financial institutions. This is very important because it provides the ultimate form of liquidity in the financial system.
Thiessen wrote, “Fundamentally, monetary policy is about the pace of monetary expansion. The rate at which the central bank allows base money to expand over time will either encourage or restrain the financial system in its expansion of money and credit. This in turn will influence the demand for goods and services in the economy. And it is the level of demand relative to the ability of the economy to produce goods and services that eventually determines the rate of inflation.”
The Bank of Canada relies on the linkage from base money to (interest rates + the exchange rate), and from these financial market prices to aggregate demand and then to inflation, as the basis for making monetary policy decisions in Canada.
Thiessen stated, that
the relationship of base money to aggregates of money or credit, or to measures of aggregate demand in the economy is not stable enough for the Bank of Canada to operate by expanding base money at a given rate.
In the macroeconomic context, aggregate demand (AD) is the total demand for final goods and services in the economy at a given time and price level. It is the amount of goods and services in the economy that will be purchased at all possible price levels.
This is the demand for the gross domestic product of a country when inventory levels are static. It is often called effective demand as well, though at other times this term is distinguished.
Of course, the linkages from monetary actions through to the rate of inflation have been subjected to intense scrutiny over many years by academics and other intellectuals.
Some parts of the transmission mechanism, such as the effect that changes in interest rates have on aggregate demand and inflation, have received much greater attention.
Other parts, such as the linkages from central bank actions, to movements in interest rates and the exchange rate, have received less attention outside of central banks.
The following video titled: Bank of Canada Count on Us portrays an easy to understand explanation of the BoC’s goals.
The video discusses: that as long as inflation is low, stable and predictable, then Canadians can stay confident in the future value of money. The Govt of Canada and Bank of Canada aim for an annual inflation rate of 2%. This is called the inflation target
So how does the Bank of Canada keep inflation in check? The interest rate announcement happens 8 times a year
The Bank of Canada sets the policy interest rate (overnight rate), which influences commercial interest rates. For consumers, low interest rates mean it costs less to borrow money, and mortgages are cheaper and so are lines of credits
For businesses, low cost helps them buy new equipment and in expanding operations. Now, all this activity in the economy tends to push inflation up.
But with high interest rates, borrowers are less inclined to borrow, savers are more inclined to save, everyone is spending less, and when this happens, inflation tends to fall.
The Bank’s goal is to control inflation…keeping it low, stable, and predictable
Monetary policy works in a symmetric fashion. Thus if there was a situation where the economy was over heating, and when faced the risk that inflation would rise above the bank’s target, then interest rates would rise and those higher rates would serve to slow the economy down again and bring inflation back down again
Contained within the video, a Bank of Canada official stated that in 2008-09, Canada faced a synchronized recession with the global banking meltdown. In a response to that, the Bank lowered it’s policy interest rate to a record level. As a result, the Canadian economy was able to recovery relatively quickly
Current Bank of Canada Chief Mark Carney, had said in the video that Canada learned the cost of high inflation in the 70’s, and early 80’s, on the price of inflation. There were efforts made by those in the Bank of Canada to bring inflation down to levels that are low, stable, predictable and where it ceased to be part of people’s thinking.
In the current condition of things, money moves through a financial system, just like water moves through pipes. Everyday, there are millions of transactions taking place in Canada between people, businesses, and in the financial markets (buying stocks and bonds). The Central Bank’s job is to oversee the large complex systems that are used for making the financial transfers each and every day
If these systems don’t work well, they can be tremendously disruptive.
Part 2 looks into the Transmission Mechanism that the Bank of Canada uses in order to set monetary policy for the whole of the economy.