Despite its proximity to the United States, the Bank of Canada has gradually escaped the U.S. Federal Reserve Bank's shadow while acknowledging that it must factor U.S. monetary policy moves into its decision making process. The Bank has an inflation target range of 1 percent to 3 percent range with a specific focus at the 2 percent midpoint. To better track inflation, the Bank uses a core consumer price index that excludes eight volatile components — fruits, vegetables, gasoline, fuel oil, natural gas, mortgage interest, intercity transportation and tobacco products (as well as the effect of changes in indirect taxes on the remaining components.)

 

Monetary policy goals are expected to contribute to solid economic performance and rising living standards. This is achieved by keeping inflation low, stable and predictable. At the heart of monetary policy is the inflation-control target that the Bank of Canada and the government have established for Canada. The level of interest rates and the exchange rate determine the monetary conditions in which the Canadian economy operates.

 

The Bank of Canada decided to establish an inflation target in February 1991, announcing in conjunction with the government, a series of targets for reducing inflation to the 2 percent midpoint by the end of 1995. Year-over-year inflation was running over 6 percent when the targets were implemented. The agreement has been extended several times, with the latest renewal taking place in December 31, 2011.

 

Given the proximity to the United States, the Bank also has to factor U.S. interest-rate policy into its decisions. The spread between U.S. and Canadian interest rates and the relative value of their currencies dictate the flow of large amounts of capital. Since late in 2000, Bank has announced policy changes eight times a year along with an assessment of the Canadian economy. (In the past, the Bank of Canada was forced to respond immediately to changes in Fed policy). The Bank of Canada does keep the option of altering policy between official announcements.

 

 

The Bank carries out monetary policy by influencing short-term interest rates by setting the overnight target. This in turn affects monetary conditions — that is, the impact of short-term interest rates and the Canadian dollar's exchange rate on the economy. The transmission of monetary policy occurs as changes in monetary conditions affect the demand for goods and services. Lower interest rates, for example, tend to increase spending and reduce savings, and a lower dollar can boost exports and hold back imports. Conversely, higher interest rates tend to curb domestic spending and a higher dollar tends to curb exports and encourage imports. Strong demand for Canadian goods and services puts upward pressure on prices if it exceeds the economy's capacity. Changes in monetary conditions affect inflation only indirectly and are usually felt over a period of 18 months to two years.

 

Monetary policy goals are to aid and abet solid economic growth along with rising living standards. To achieve these goals, inflation is kept low, stable, and predictable. The inflation control target is at the heart of Canadian monetary policy. The level of interest rates and the exchange rate determine the monetary environment in which the Canadian economy operates. Inflation targeting has been a cornerstone of monetary policy since 1991, when the government and the Bank of Canada agreed to target inflation for a five-year period. The Bank and government have updated the agreement every five years since with the most recent renewal occurring in November 2011.

 

Specifically, the Bank aims to keep the rate of inflation, as measured by the year-over-year percent increase in the CPI, inside the target range of 1 percent to 3 percent. The CPI was chosen as inflation's measure because it was well known to the population. The Bank aims to keep inflation near the 2 percent midpoint. Although the inflation target is stated in terms of the total CPI, the Bank uses a measure of core inflation as an operational guide. The measure, in their opinion, provides a better measure of the underlying trend of inflation and tends to be a better predictor of future changes in the total CPI.

 

 

After remaining at 4.25 percent between May 2006 and July 2007, Bank of Canada's policy interest rate was increased to 4.5 percent at their July 2007 meeting where it remained until December of that year. But since then, the Bank lowered its key rate at the December 2007 and the January, March and April 2008 meetings. The Bank of Canada participated in the coordinated 50 basis point interest rate cut on October 8, 2008 along with the Federal Reserve and the Bank of England among others. It subsequently cut rates to 2.25 percent at its October meeting and by 75 basis points to 1.5 percent at its December meeting. In March 2009 it lowered its policy rate to 0.5 percent and at its April meeting to 0.25 percent. The Bank of Canada stated that it would keep its interest rate at 0.25 percent into 2010. At its April meeting, the BoC dropped that promise but left the markets guessing when and whether a rate increases would take place. The markets did not have long to wait — the BoC increased its key rate by 25 basis points at its June 2010 meeting to 0.5 percent, in July to 0.75 percent and in September to 1.0 percent. It remained at 1.0 percent until the BoC's surprise 25 basis point cut in January 2015. The target for the overnight rate was reduced to 0.75 percent and the deposit rate and the Bank Rate were lowered to 0.50 percent and 1.0 percent respectively. The move in large part reflects the impact on the Canadian economy of the recent dramatic slide in oil prices and the consequent significant downgrading of the Bank's economic outlook. After its March, April and May meetings, the rate remained at 0.75 percent.

 

At its July meeting however, the BoC lowered its key interest rate by another 25 basis points to 0.5 percent. The deposit rate was lowered to 0.25 percent and the Bank Rate to 0.75 percent. The second 25 basis point cut this year reflected a significant downgrading of the BoC's near-term growth projections, itself attributable to an unexpectedly large negative impact from the collapse in oil prices as well as weaker other non-energy commodity and non-commodity prices. In April the BoC's forecast for second quarter GDP growth was 1.8 percent (SAAR) but this has now been slashed to minus 0.5 percent, effectively putting the economy into recession.

 

January's 25 basis point cut was supposed to preempt the main effects of the oil price slump but in practice industry was hit unexpectedly hard. The follow-up move should quash talk of any further easing for the time being but the willingness of the BoC to act now will ensure financial markets continue to follow the economic data very closely.