As many major Canadian news outlets reported this week, the Bank of Canada raised its interest rates to 1.75 per cent. If you’re unsure about that, you’re not alone.
The Bank of Canada’s purpose and responsibilities aren’t widely understood among young Canadians.
The Journal sat down with the Head of the Economics Department, Huw Lloyd-Ellis, to shed some light on the world of monetary policy.
This interview has been condensed and edited for clarity.
QJ: What’s the purpose of having a central bank?
Central banks are involved a lot in regulation of what banks are allowed to do. This includes what functions they’re allowed to have, what kinds of things they can do, and what kind of assets they can invest in. They also do a lot of research on the economy in general. It’s not just about setting the interest rates.
If you look at their mandate, it’s to achieve price stability. Put more precisely, what they’re trying to do is achieve a low and stable rate of inflation. They currently have a target [of] around two per cent per year.
The inflation rate is related to what is going on in the economy. The Bank influences what goes on in the economy through their interest rate policy. Although their goal is to achieve low and stable rate of inflation, their polices effect what happens to everything else.
Why does the Bank raise and lower interest rates, and what kind of effect does that have on the economy?
There are lots of interest rates in the economy and one way they vary is in terms of [the] length of time until they’re paid off. There are long-term interest rates and short-term interest rates. The shortest-term interest rate is what’s called the overnight rate, the one that the central bank influences.
Every day, all the commercial banks need to settle their accounts. They have customers completing transactions with people whose accounts are at other banks. At the end of every single day, they need to clear those accounts. [Commercial banks] borrow money from other banks to clear those accounts with each other.
The central bank always stands ready to borrow or lend to these banks to settle those accounts. They charge an interest rate for this. Since there’s so much money flowing through the central bank in this way every day, if you alter how much the commercial banks pay through the overnight rate, that’s going to seriously impact their costs of doing business.
If a commercial bank has to pay more to borrow overnight, their costs go up [and] they may charge people higher interest rates to make up for the extra cost. It’s like any other business: if the marginal cost of doing business goes up, the cost of what you charge people goes up.
By influencing interest rates, you’re trying to influence what people do. If the interest rate goes up, then people are less willing to borrow, invest and consume. If you influence those things, you influence that economic activity. If you want to control inflation, or movement in price level, you want to affect this activity.
If you want a lower rate of inflation because people are buying less stuff, then you may want to raise the interest rates so they spend less. If people spend less, then prices rise less. But that dampens economic activity, so you’re doing it to keep the inflation in a certain range.
It’s like a game where you try to guess the trend of where the economy is going to go. You don’t want it to grow too fast or too slow because that will make inflation go too high or too low.
One concern is how it will impact the economy given that many Canadians carry a lot of debt. What are your thoughts on that?
Part of why Canadian consumers are carrying a lot of debt right now is because they’re paying a lot more for houses than they used to, particularly in big cities.
In this context, because of the financial crisis where interest rates were so low, people went to borrow more and buy bigger houses. The consequences for people now is that their interest rates are going up and they’ll have a hard time paying back loans.
Even though [interest fluctuations] are tiny movements, that has huge effects on these loans and the amount you have to pay every month.
If the Bank wants to increase interest rates, they should be careful. If people can’t afford stuff, they stop spending, and you can head into a recession. That’s the worry, and it’s a good one.
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