In a press release dated October 26, 2022, the Bank of Canada (BoC), Canada’s central bank, explained that inflation remains at higher than normal levels, even though it has declined slightly from its peak of 8.1 per cent in June 2022 to 6.9 per cent in September 2022. “The economy is still in excess demand—it’s overheated. Households and businesses want to buy more goods and services than the economy can produce, and this is driving prices higher,” states Tiff Macklem, the Governor of the BoC, in a press conference for the Monetary Policy Report—October 2022.
To further curb inflation, on October 26, 2022, the BoC increased its policy interest rate—also named the target for overnight rate—from 3.25 per cent to 3.75 per cent. This growth marks the sixth successive raise since March 2022, before which the rate was 0.25 per cent. The target for overnight rate is used in the overnight market, where financial institutions borrow money from each other for a single day to settle payments to their customers.
The Medium spoke with the University of Toronto Mississauga Department of Economics professor, Angelo Melino, about the state of the Canadian economy and the BoC’s monetary policy.
Melino states that a direct impact of a higher policy interest rate is the cost of borrowing increases for loans that need to be repaid within shorter timeframes. As the target for overnight rates rise, financial institutions will pass on the extra cost to its borrowers. Thus, fewer households and businesses will take on debt to make purchases and investments, leading to a reduction in aggregate—the economy’s total—demand. This works towards fixing the economy’s misaligned supply and demand.
Considering that the BoC had first increased the policy interest rate back in March 2022, the BoC reports that “interest-sensitive areas of the economy” have already experienced changes. Notably, the housing market has seen reduced activity—which has a noticeable impact on reducing aggregate demand. “A large part of the economy is driven off the housing market. Think about real estate agent fees, lawyers’ fees, […] furnishings. […] There’s a lot of renovation that gets done when people buy homes as well,” contends Melino.
As the increased interest rate spurs consumers to delay big purchases, Melino expects the market for what are known as “white goods”—large electrical appliances, such as refrigerators and stoves, that are costly and not purchased as frequently—is likely be affected.
In conjunction with adjusting the policy interest rate, the BoC has also been implementing quantitative tightening (QT)—which aims to cool down the economy—since April 13, 2022. This process is the opposite of quantitative easing (QE)—which aims to stimulate the economy. In April 2020, the BoC implemented QE to stimulate the bond market, which was heavily impacted by the Covid-19 pandemic. According to the BoC’s staff analytical notes published September 2022, under QE, the BoC purchased “government bonds in exchange for settlement balances,” which are “deposits that major Canadian banks hold at the [BoC].”
After QT began, the BoC held its Government of Canada bonds to maturity and “[stopped] reinvesting the proceeds of principal and coupon repayments.” The BoC expects that households and businesses may withdraw their deposits from banks to purchase new Government of Canada securities, filling the void that BoC left behind when it stopped reinvesting into government bonds. This reduces the amount of money flowing in the economy and counteracts “inflationary forces.”
“So, we would expect long term interest rates to go up a little more than they would otherwise, because of the quantitative tightening,” states Melino. He goes on to explain that long term interest rates have a sizeable impact on economic activity. “Companies that invest are often more interested in longer term interest rates than the overnight interest rate.”
Regardless of the implemented initiatives, the BoC expects economic recovery to be a slow and steady process. Macklem explains in a press conference that “there are no easy outs to restoring price stability,” and that the economy must steadily readjust its supply and demand levels. Due to the monetary policies implemented, the Bank of Canada expects the growth of the Canadian economy to be stunted in upcoming quarters, after which the economy will recover amid normal and stable levels of inflation.
Prospectively, Macklem expects the policy interest rate to be increased further, with the magnitude dependent on the efficacy of implemented monetary policies at cooling down the overheated Canadian economy. The next interest rate announcement is slated to take place on December 7, 2022.