Mathieu Frigon and Michaël Lambert-Racine
Economics, Resources and International Affairs Division
Monetary policy is one of the two key components of the Government of Canada’s economic policy, the other being fiscal policy. Fiscal policy includes measures by the government to raise revenue (taxation, user fees, etc.) and spend funds (transfers, programs, etc.), whereas monetary policy refers to measures by the central bank – the Bank of Canada – to influence the quantity and value of money in circulation.
Parliament must approve decisions pertaining to fiscal policy, but not to monetary policy. However, as the legislative body, Parliament is ultimately responsible for the Bank of Canada Act, the statute governing the operations of the organization responsible for monetary policy.
This HillNote explores the relationship between Parliament and the Bank of Canada, as well as the potential impact of monetary policy on the work of parliamentarians.
Monetary policy: Objective and tool
The objective of monetary policy is to preserve the value of money by keeping inflation low, stable and predictable. The inflation-control target is set at 2%, the midpoint of a 1% to 3% target range.
The main tool used by the Bank of Canada to conduct monetary policy is the adjustment of the target for the overnight rate (also known as the “key policy interest rate”). The Bank does not directly adjust the amount of money circulating in the Canadian economy; instead, it tries to influence this amount by changing the cost of borrowing (interest rate).
Legislative and institutional framework
The objectives of the Bank of Canada Act, set out in its preamble, have not changed since the legislation was enacted in 1934. The Act generally aims to promote the economic and financial welfare of Canada, essentially by
- regulating credit and currency;
- controlling and protecting the external value of the national monetary unit; and
- mitigating by its influence fluctuations in the general level of production, trade, prices and employment.
Other than in the preamble, the Bank of Canada Act makes no mention of the objectives informing the Bank’s operations and powers.
Inflation control as a key objective of monetary policy, then, is not mentioned in the legislation. Instead, this objective originated in a 1991 joint statement by the Minister of Finance and the Governor of the Bank of Canada, which set a series of targets “for reducing inflation and establishing price stability in Canada.” In 1993, both parties agreed to keep inflation within a target range of 1% to 3%. This agreement was renewed by other joint statements in 1998, 2001, 2006 and 2011 and is subject to renewal by 2016.
While the objective of monetary policy is decided jointly by the Bank of Canada and the government, the Bank enjoys considerable independence with respect to the conduct of monetary policy.
However, section 14 of the Bank of Canada Act does place certain limits on this independence. If there is a difference of opinion concerning the monetary policy to be conducted, such as a disagreement on the adjustment to the key policy interest rate, the Act allows the Minister of Finance to give to the Governor of the Bank a written directive in specific terms and applicable for a specified period. The directive must be published without delay in the Canada Gazette and laid before Parliament within 15 days of its transmission to the Governor of the Bank.
Ultimately, the Bank of Canada is also accountable to Parliament, particularly through the tabling of its annual report and through consideration by a parliamentary committee of its quarterly monetary policy reports.
Impact of monetary policy on fiscal policy
The Bank’s decisions concerning the key policy interest rate – the monetary policy tool – have major implications for fiscal policy through their potential impact on economic growth, on the one hand, and the federal government’s cost of borrowing, on the other hand.
Regarding economic growth, for example, a rise in the key policy interest rate could lead to an economic downturn, which could then result both in decreased revenues, such as those obtained from personal income taxes and consumption taxes, and in increased costs for certain programs, such as employment insurance.
Adjusting the key policy interest rate has a direct impact on the federal government’s cost of borrowing, as illustrated in Figure 1. The figure shows the close relationship between the change in the key policy interest rate and the average rate of interest on federal government market debt over the last 30 years.
Figure 1 – Average Rate of Interest on Federal Government Market Debt and the Key Policy Interest Rate, 1985–1986 to 2013–2014 (%)
Sources: Figure prepared by the authors using data obtained from Bank of Canada, Key Interest Rate: The Target for the Overnight Rate and historical interest rates (since there was no official key policy interest rate between 1986 and 1996, the key policy interest rate for this period was estimated by deducting 0.25% from the Bank of Canada rate); and Public Works and Government Services Canada, Public Accounts of Canada, 1975 to 2014.
As shown in Figure 2, although market debt as a percentage of gross domestic product (GDP) grew significantly starting in 2008, the federal government’s interest costs continued to decrease to a record low of 0.9% of GDP in 2014. This decrease is due mainly to the reduction in the average interest rate on federal government market debt, itself caused by cuts made to the key policy interest rate by the Bank of Canada during the period.
Figure 2 – Federal Government Market Debt and Market Debt Interest Costs, 1985–1986 to 2013–2014 (% of Gross Domestic Product)
Sources: Figure prepared by the authors using data obtained from Public Works and Government Services Canada, Public Accounts of Canada, 1986 to 2014; and Statistics Canada, Table 380-0064: Gross domestic product, expenditure-based, CANSIM (database), accessed 15 October 2015.
Given the impact that monetary policy can have on economic growth and federal finances, it can be said that it ultimately influences fiscal policy decisions and therefore the work of parliamentarians.
Becklumb, Penny, and Mathieu Frigon. How the Bank of Canada Creates Money for the Federal Government: Operational and Legal Aspects. Publication No. 2015-51-E. Library of Parliament, 10 August 2015.
Stuckey, Brett. A Primer on Inflation Targeting. Publication No. 2011-111-E. Library of Parliament, 9 November 2011.
Yong, Adriane, and Brett Stuckey. Bank of Canada’s Monetary Policy Report: The Quarterly Assessment. Library of Parliament, 26 October 2011.