Through its monetary policy tools, the Bank of Canada can starve the financial system of money, or flood the system, to get rates back to within its desired operating bands.
The latest announcement by the Bank of Canada makes it almost certain the Bank Rate will remain at 0.50 per cent, and the target overnight interest rate will stay at 0.25 per cent until 2023.
The message was quite forthright, especially from an organization that is more used to using many words to say very little. It may not be so intuitive, though, how the Bank ‘sets’ interest rates, and how it keeps them at or near the level that is consistent with its economic policy objectives. Below, we seek to shed some light on the matter.
Fundamentally, the Bank of Canada picks an interest rate that it believes is consistent with its economic policy objectives. Whatever rate it picks, the Bank’s intention is to maintain a proper balance between the risk of inflation, unemployment, the value of our dollar, the trade balance and so forth.
Overnight interest rate is BoC’s prime tool
The rate the Bank picks is called the overnight interest rate. The Bank believes that if it can control the overnight rate, other interest rates, such as the prime rate, mortgage rates, bond yields, etc., will take their cue from the signals the Bank is sending, and will adjust accordingly. The overnight interest rate, the one the Bank manipulates, is the rate at which banks and investment dealers are willing to lend each other money overnight to correct clearing deficits that have resulted from the day’s transactions.
The Bank of Canada does have a target rate for where it would like the overnight rate to be; however, in the past, it has determined a 50-basis point wide range within which it would let the overnight rate fluctuate. This 50-basis point range was called the operating band. This year, however, the Bank narrowed the band to 25 basis points in view of the liquidity operations it has undertaken due to the fallout from the coronavirus. The top of the band is always the current Bank Rate. Right now, the bank rate is 0.50 per cent, which means the current operating band ranges from 0.25 per cent to 0.50 per cent.
As long as the country’s big banks and investment dealers do business with each other within this range, the Bank of Canada is happy. Under normal circumstances, it has preferred these financial institutions to concentrate their deals at the mid-point of a 50-basis-point range. This mid-point was the target overnight interest rate. Now the target is set at the lower end of a 25-basis-points range, or 0.25 per cent.
Bank also has monetary policy tools
So what happens if the Bank of Canada discovers that banks and investment dealers are transacting loans below 0.25 per cent, or above 0.50 per cent; that is, outside of the operating band? That’s when the Bank can step in with is monetary policy tools, such as repurchase agreements (repos) to bring interest rates down to within the desired range, or reverse repurchase agreements (reverse repos) to bring rates back up into the intended range.
Through these monetary policy tools, the Bank can either starve the financial system of money, or flood the system with it as the case may be, to get rates back to within the desired operating bands.
Given the current crisis, it’s almost a certainty that we’ll be dealing with the current operating band, with a target overnight interest rate of 0.25 per cent, for a while yet. Indeed, the Bank of Canada foresees no reason to increase the rate until 2023.
This is an edited version of an article that was originally published for subscribers in the November 13, 2020, issue of Money Reporter. You can profit from the award-winning advice subscribers receive regularly in Money Reporter.
Money Reporter, MPL Communications Inc.
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