Monetary Policy & Bank of Canada

Monetary Policy and the Bank of Canada

• This lecture explains the functions of the Bank of Canada, the objectives of monetary policy, and how the bank implements monetary policy.

Introduction

• Central banks are key to the monetary/financial system, primarily managing monetary policy.
• The Bank of Canada aims to promote economic and financial welfare for Canada, defined by the Bank of Canada Act.
• The Bank of Canada uses the overnight rate to maintain low, stable, and predictable inflation.
• Bank of Canada decisions impact interest rates, financial markets, aggregate demand, and inflation.
• The Office for the Superintendent of Financial Institutions, not the Bank of Canada, regulates and supervises Canadian financial institutions.

Organizational Structure

• Established in 1935 after the Great Depression, the Bank of Canada was originally a private institution.
• The Bank of Canada was nationalized in 1938.
• Compared to other central banks, the Bank of Canada is relatively young.
• Older central banks include:
  • Sweden (1656)
  • U.K. (1694)
  • France (1800)
  • Japan (1882)
  • U.S. (1913)
• The Bank of Canada's overall responsibility rests with a 15-member Board of Directors.
• The Board of Directors consists of the Governor, Senior Deputy Governor, Deputy Minister of Finance, and 12 members appointed by the Minister of Finance for three-year terms representing diverse occupations from all regions of Canada (excluding banking).
• The Board of Directors provides general oversight (strategic planning, officer recruitment, budget).
• The Governing Council holds collective responsibility for management, especially monetary policy and financial stability.
• The Governing Council includes the Governor, Senior Deputy Governor, and four deputy governors.
• The Governor and Senior Deputy Governor are appointed by the Board of Directors with approval from the Minister of Finance, serving seven-year terms.
• The Bank of Canada is a crown corporation and an independent institution.
• It has full independence in conducting monetary policy with the goal of low and stable inflation.
• The objective of monetary policy is agreed with the Minister of Finance.
• It is reviewed and renewed every five years, with the next agreement in 2026.
• Since 1991, the Bank of Canada has aimed to maintain the rate of change in the consumer price index (CPI) between 1% and 3%, targeting 2%.

Functions of the Bank of Canada

• The Bank of Canada has five main functions:
  • Currency management
  • Financial system management
  • Funds management
  • Monetary policy
  • Retail payments supervision
• However contrary to popular belief it is not responsible for:
  • Regulation and supervision of financial institutions (OSFI)
  • Issuance of coins (The Mint)

Currency Management

• The Bank of Canada has a monopoly on issuing banknotes and is responsible for their design, production, and distribution.
• The Bank of Canada distributes banknotes to financial institutions, ensuring adequate supply for public demand.
• Commercial banks exchange reserves with the Bank of Canada for new banknotes.

Funds Management

• The Bank of Canada manages funds for the government, other governments, central banks, and itself.
• The Bank of Canada is the fiscal agent and banker for the Government of Canada, managing the accounts of the Receiver General and ensuring sufficient cash for daily government needs.
• Services provided to the Government of Canada:
  • Managing borrowing to replenish reserves.
  • Investing surplus reserves.
  • Advising on federal debt management for stable, low-cost funding.
  • Buying foreign exchange.
  • Hedging foreign currency positions.
  • Engaging in gold transactions.
• The Bank of Canada provides banking facilities to participants in Canada's payment systems.
• It oversees financial market infrastructure, including clearing, settlement, and securities settlement systems.
• Canada's clearing and settlement system provides infrastructure for financial institutions to settle payments.
• The securities and settlement system provides the framework for exchanging securities, derivatives, and financial assets.
• Lynx is central to Canada's clearing and settlement system, enabling real-time transaction settlements with a guarantee.
• Systemic risk, where problems in the clearing and settlement system spread, is a key concern for the Bank.

Financial System

• The Bank of Canada fosters secure and efficient financial systems nationally and internationally.
• It provides liquidity to financial institutions as the lender of last resort, a crucial function of any central bank.
• The Bank of Canada provides credit to financial institutions needing liquidity that cannot borrow from other financial institutions or capital markets.

Objective of Monetary Policy in Canada

• Since February 1991, monetary policy aims to maintain the 12-month rate of change in the headline CPI within 1-3%, targeting 2%.
• The Bank of Canada focuses on low, stable, and predictable inflation to promote low unemployment and raise living standards.

Tools and Framework of Monetary Policy

• The Bank of Canada believes it can influence aggregate demand via the overnight rate.
• The overnight rate is the interest rate banks use when borrowing from one another for one-day loans, is the primary tool.
• To reduce aggregate demand, if inflation is above its target the overnight rate is increased.
• The Bank of Canada determines the overnight rate level eight times annually.

Inflation Targeting in Canada

• Previously, the Bank of Canada used fixed exchange rates and monetary targeting while focusing on price stability by managing interest rates rather than the money supply.
• In the 1980s, the Bank of Canada transitioned to inflation targeting due to the economic boom, oil price increases, and the introduction of the GST.
• The Canadian government then agreed with the Bank of Canada on targeting the CPI resulting in official planning for inflation targeting in the late 1980s followed by full implementation in February 1991.
• Canada was the second country after New Zealand to adopt formal inflation targeting.
• Over 70 countries have since adopted this framework, enhancing monetary policy transparency.
• Inflation targeting has led to greater independence, accountability, and transparency.
• Senior Bank of Canada officers give regular speeches and issue reports like the Monetary Policy Report and the Financial System Review.

Greater Independence

• Independence ensures that monetary policy is free from political influence.
• Accountability and transparency are achieved through speeches and reports.
• The governor and deputy governors influence economic agents' expectations.

Why Central Bank Independence Matters

• Independence builds public and market trust by being free from political interference.
• Independence separates monetary and fiscal policy, preventing political temptation to reduce public debt value through inflation
• Independence enables focus on long-term price stability rather than short-term political gains which includes potentially harmful policies around elections.
• Empirical studies link central bank independence with decreased inflation and well-anchored long-term inflation expectations.

Why Target Inflation?

• Inflation targeting makes inflation predictable, anchoring expectations and reducing inflation's real costs.
• Predictable inflation helps consumers and firms plan long-term purchases and investments.
• Low, stable inflation makes wage settlements easier and avoids the wage-price spiral seen in the 1970s.

Inflation Targeting and Expectations

• Low, stable inflation cuts reduces the costs associated with inflation and improves economic performance.
• Low inflation reduces volatility in inflation and overall economic variables.
• A stable economy enables economic agents to plan spending and investment effectively.

Inflation Targeting in Canada (1980-2023)

• Inflation decreased with Inflation targeting which was implemented from January 1980 to December 2023 within Canada.
• In January 1991 targeting began with a 4% target as it was too high, it included a band of plus or minus 3%.
• Implementation of a 2% target at the time when actual inflation was around 7% would not have been credible and increased interest rates, risking a contraction in demand.
• The target was gradually lowered, with the 12-month CPI target set to 2% plus or minus one percent in December 1995.

Inflation Rates and Targets

• Inflation fell within the 1-3% band before 1995.
• Since the implementation of inflation targeting, it has stayed predictably low except for persistent deviations from the Bank of Canada's target since January 2021 until recently.

Effects of Inflation Targeting

• Inflation targeting has reduced average inflation rates and volatility.
• Inflation expectations have fallen and have been anchored around 2% (until recently).
• Anchoring inflation expectations around 2% is vital.

Inflation Statistics

• There has been a moderation in inflation from 1980 to 2020 where both the arithmetic mean and standard deviation of inflation fell.
• Details include:
  • 1980-1989:
    • Mean 6.0
    • Median 4.6
    • Standard Deviation 3.0
  • 1990-1999:
    • Mean 2.0
    • Median 1.7
    • Standard Deviation 1.5
  • 2000-2009:
    • Mean 2.0
    • Median 2.1
    • Standard Deviation 1.0
  • 2010-2019:
    • Mean 1.6
    • Median 1.5
    • Standard Deviation 0.8
  • 2020-2024:
    • Mean 3.4
    • Median 3.1
    • Standard Deviation 2.2

Inflation Expectations

• Inflation and inflation expectations fell from 1980 to 2020.
• Inflation expectations can be predicted through surveys and measuring yield differences between long-term nominal bonds and real-return bonds.
• A decrease in inflation expectations occurred after successful inflation targeting.
• Being anchored around 2% marks increased credibility due to adhering to promises.

Measuring Expectations

• Bond markets are one of the means of measuring inflation expectations.
• Real-return bonds provide inflation-adjusted returns and guarantee the real interest rate unlike nominal return bonds.
• Based on the Fisher equation, real interest is equal to nominal interest minus expected inflation (r = i − πº).
• Expected inflation is equal to the nominal interest minus real interest πº = i-r and therefore the difference in yield gives a measure of inflation expectations.
• The measure of inflation expectations is shown in the next slide, and it is clear that inflation expectations fell rapidly following the implementation of the inflation targeting in 1991

Why 2%?

• The Bank of Canada targets 2% inflation due to economic research indicating costs of inflation exceed the 2-3% range.
• Inflation over 3% becomes costly over time.

Why Not Zero Inflation?

• Downward nominal wage rigidity prevents zero level as wages are rigid downward which prevent wages from easily adjusting when they need.
• Zero lower on nominal interest rate bound by zero, preventing adjustments when monetary stimulus are needed.
• Bias in the CPI target of zero may target negative rate due to tendency of CPI to overstate cost of living.

Policy Instrument of the Bank of Canada

• The main policy instrument is the overnight rate, which is the rate financial institutions pay when borrowing from each other in the overnight market.
• Quantitative easing (QE) and forward guidance (FG) are used as unconventional tools when interest rates approach zero.
• Quantitative Easing consists of the purchase of government securities or other financial assets to inject liquidity into the economy, lowering interest rates to stimulate borrowing and investment
• Central banks utilize Forward Guidance as a monetary policy tool, communicating future interest rate plans to influence market expectations.
• The Bank of Canada employed Forward Guidance during the 2008-2009 financial crisis and Quantitative Easing during the Covid-19 pandemic.

Policy Instrument

• To acheive achieve its target the Bank of Canada determines the appropriate level of the overnight rate to achieve its objective of 2% inflation eight times a year via a monetary policy.
• This has occured since 2000, using a system of eight pre-announced fixed action dates (FADs).
• Transparency is reinforced as economic and financial decision makes are aware of the set levels.

Implementation

• The Bank of Canada implements monetary policy by adjusting the target.
• The actual rate is the interest paid rate on over-day loans between financial institutes within Lynx.

Settlement Balance

• An overnight rate decides interest and supply from financical institutes and their settlement balances.
• Bank of Canada sets multiple tools including a series of financial institute accounts.

Canadian Inflation

• To acheive a 2% target, the Bank of Canada will target overnight rate and reduce balance with their target overnight rate.
• They acheive this through tools to reduce their supply, and reverse those accounts the next day.

Cost of Borrowing

• By raising both the target and the overnight interest rate, it is able to raise their cost of borrowing for banks.
• Higher costs are passed onto consumers through loans, reducing demand and investment to alleviate financial pressyre.

Bank's Interest

• If interest is expected to fall below their 2% target, overnight rates will decrease with their balance with it's target.
• With costs also incentivizing a fall, investment and consumption will increase by stimulating the economy.
• The Bank of Canada plans to be symmetric and plans on rising on either side of that threshold.

Lynx Implementation

• Canada monetary policy is impemented through Lynx.
• The electronic system is made of financial and public payments secured through wire.
• The method is critical to the economy using secure economic transfers.
• 87% of the entire payment system is done with Lynx for financial support.

Participants in Lynx

• There are 17 institutions who participate in Lynx with the Bank of Canada.
• The are all:
  • Members of the Canadian Payments Association
  • All participate in a SWIFT system
  • Maintain a settlment with the Bank of Canada
  • Access a liquidit facility offered by the bank of Canada
• 50,000 payments using about $500 billion per day are created, making 87% of the systems value.

Lynx Settlemet

• Lynx member will create payments receiving them between organizations.
• Deficiet or Surplus position will denote net gains, and money they owe respectively.
• Banks create a long or short position with any surplus or deficit payment.

Defeciit Lynx

• With Lynx, the amounts should equally match between positions since is closed-loop.
• With this game being zero-sum, Lynx requires a net of members to equal zero as well.
• With members in deficit or surplsu, this results in loans.
• Borrow members and allow to have a interest rate which closes daily positions.

Liquid and the Bank

• Bank cover losses by borrowing to set losses.
• Loans include daily interest charges making overnight payments.

Target Rate

• Target aims to regulate overnight rates which usually reach 3% as of present.
• Bank of Canada also influences balances to make the actual value near estimates.

Position

• If banks can deposit and invest their position, the Banks of Canada will have those funds overnights.
• The deposit rate is at 0.05% for January 2025 to encourage other members with limited borrowing.
• The lending rate can reach up to 0.25 above rates based of position over a base.

Rates

• The target overnights aim for Bank of Canada's rate of payments.
• This value varies between the present rate and what is above the baseline.
• Since 2022, they have employed a floor system since recent changes.

January

• The bank's overnight rate fell 3% to $3.25 with deposit at $2.95, marking
• The broad shifts suggest their are indicators and a 2yr underlying rate of 2% along with surveys.

Inflation

• There are expected volatility due to consumers as Shelter Prices are gradually elevated.
• The recent drop from GST marks consumer easing with their price.

Limits

• Floo rates create a floor amount.
• Balances create an injection making it close to target, and easy implementation.
• This gives Canada more control.

Banks and Canada

• The interest rate must always stay under band
• Bank can acquire loan at their own rates but will never need to.
• Payments then puts a floor before banks create funds from banks.

Implementation

• With all rates guaranteed, overnight rates occur as a result.
• Using those tools, Canada finds that it can effectively stay close due to accuracy.

Influence

• They operate to influence the market from borrowing and ultimately all related consumer values.
• If inflation rises above the 2% target, they increase borrowing.
• If decreasing from for example 4.5 and 4.25% is lowered by 25bps or .25 %, the rates overall decreases.
• The Bank will then provide the operations with actual targets, ultimately creating results.

Banks in Operating

• Banks shift by providing their settlement value or creating government loans.
• This ensures payments and loans are consistent on an ongoing balance.

Value

• Values go to financial institutions, in theory increasing stability and system values.
• On the receivng end, those are removed, resulting in increased liquidity for members in the operation.
• They decide that inject or remove daily level needs to make levels consistent.

Balances and Loans

• The country typically creates loans and a resale method.
• It can increase or repurchase the value based on the loans to reinforce the current economy.

Government

• Government are useflows with what's provided in Canada's accounts to change the government funding.
• Balances then increases due to accounts and Lynsx participation.

Canada's Impact

• Government increase revenue for the funds and transfer money with Lynsx members.
• These actions affect the level and the value.

$100

• There is a .1 million decrease is the economy to the government, so it's easy to maintain target values.
• If they want to maintain their overnight funding they need other loans or reverse that value.

Injections

• Government can also perform $100 million loans, or inject payments to members for balances.
• Members then transfer more liquidity into the overall market.

Auctions

• Auctions occur twice daily in Canada.
• They maintain balance in different levels as a result, keeping what's need close to the daily target rate.
  • Canadas also pays these fees or new bonds on this end

Maturing

• In summary, the maturing releases extra payments, creating liquidity in the payment value.
• Lynsx then needs to find buyers before reversing again and reaching the liquidity to equal payment in total.
• As an example, buyers and a bid of $100 might help regulate the entire economy.

Limits

• All accounts would use limits before needing the bond values with both being consistent to be fully released.
• Those values would then allow those loans on both levels for better settlements.

Rates

• Rates of change creates transfers and those targets allow the liquidity to decrease to affect the level.
• Their overnight rates would the be determined this way