Canadian monetary policy: a powerful tool

On February 21, Bank of Canada Governor Stephen Poloz took advantage of his visit to the Chamber of Commerce of Metropolitan Montreal to discuss the significance and limitations of monetary policy before an audience of more than 600 members of the business community.

From the outset, Mr. Poloz pointed out that the Bank of Canada has a very heavy responsibility. According to the preamble to the Bank of Canada Act, the institution’s mandate is to “regulate credit and currency in the best interests of the economic life of the nation, to control and protect the external value of the national monetary unit and to mitigate by its influence fluctuations in the general level of production, trade, prices and employment, so far as may be possible within the scope of monetary action, and generally to promote the economic and financial welfare of Canada.”

Here are the key points from his speech.

Proven effectiveness

Over time, we have seen how complicated the implementation of monetary policy can be, particularly when economic conditions vary from one region of the country to the next. The controlled inflation rate over more than a quarter century clearly demonstrates that the Bank of Canada has successfully fulfilled its mission.

To explain his point, Mr. Poloz recalled the difficult period in the 1970s. Inflation was not only much higher than it is now, it was also prone to extreme volatility. It was very difficult for both businesses and households to make informed decisions in such an unstable financial environment.

Mr. Poloz pointed out that the results of policy are now felt more quickly. Businesses and households can do longer-term financial planning. In short, economic cycles are not as severe and lead to less insecurity. One of the positive results, he added, is an unemployment rate that is increasingly low and stable.

Three limitations to take into consideration

 “Even in 1935, the drafters of the law knew that the legislation would not be all powerful. There are limits to what can be done,” said Stephen Poloz, Governor of the Bank of Canada.

Monetary policy is often summed up in somewhat simple terms: The Bank influences the inflation rate by either raising or lowering interest rates to stimulate or slow down the economy. However, as a whole, the Canadian economy is much more complex and several other factors remain out of the Bank’s control.

According to Mr. Poloz, the fact that inflation control remains the sole objective of monetary policy is the first major limitation.

 “Having only one tool for managing inflation also means that the government is not able to independently manage secondary effects without jeopardizing its control of the inflation rate.”

The recent global economic crisis highlights the second limitation of monetary policy. Indeed, maintaining a low inflation rate can lead to a dangerous increase in both economic imbalances and the financial vulnerability of Canadian businesses and households. A prolonged period of economic and financial stability like the one we have just experienced can lead people to take on too much risk and debt while also reducing the vigilance of regulatory authorities.

Finally, according to Mr. Poloz, a third important limitation of monetary policy lies in the climate of uncertainty related to global economic conditions. This statement is now truer than ever. Since the effects of decisions take a certain amount of time to materialize, the forecasting process cannot be done mechanically and requires a great deal of judgment.

The question on everyone’s lips 

The Bank of Canada Governor’s visit would not have been complete without a discussion of the raising of interest rates

Asked about this issue, Mr. Poloz said that with a key rate of only 1.75%, the central bank would not have the ability to adequately respond to a possible recession. Indeed, the gradual increase in interest rates is intended to reduce the economic shock of a possible recession. Mr. Poloz also pointed out that keeping rates too low is a risk factor for households that borrow more heavily. He emphasized that, in this context, the Bank would remain very vigilant.

 “We will monitor the data as they become available and use our judgment to respond to uncertainties and manage associated risks,” said Stephen Poloz, Governor of the Bank of Canada.

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