Monetary Policy

Low and stable inflation allows an economy to function more effectively, contributing to sound and sustainable economic performance and higher living standards for Canadians. The Bank of Canada continues to undertake research and analysis to better understand the macroeconomic implications of monetary policy.

The inflation-control agreement with the Government of Canada is renewed every five years, and the next renewal is scheduled for 2016. Between renewals, the Bank reviews the framework by monitoring the experiences of other central banks, keeping abreast of the academic literature, evaluating its track record on inflation and questioning the assumptions underpinning the agreement. Work is under way on the three key issues that were identified as priorities for the 2016 renewal: (i) the appropriate level of the inflation target in light of the recent experience with the effective lower bound on nominal interest rates and evidence that the neutral rate of interest has declined; (ii) the role of monetary policy in maintaining financial stability; and (iii) the measurement of inflation, including its biases and underlying trend.

One area of ongoing interest for the Bank concerns the macroeconomic and policy implications of low policy interest rates in Canada and internationally. In this respect, the Bank (within its monetary policy and financial system functions) continues to carry out research on unconventional monetary policies, including the exit and spillovers from these policies. Drawing on the experiences of central banks that introduced unconventional monetary policies and negative policy interest rates, issues that receive particular attention include whether unconventional monetary policies should be part of the standard toolkit and the effectiveness of negative policy interest rates.

The Bank is also working to improve its understanding of ongoing structural transformations in the Canadian economy. Part of this goal is to examine export performance in the non-commodity sector (including investment in machinery and equipment), as well as developments in the energy sector (including supply constraints). The impact of China and emerging-market economies on Canada’s terms of trade and export performance will receive particular attention. We are also developing further insights into the dynamics and productivity performance of Canadian firms. The goal is to improve our understanding of the various structural changes affecting Canada’s labour market and labour productivity—particularly the implications of demographic changes—as well as our estimates of economic slack in the economy and our understanding of the links between weakness in the labour market and underlying inflation pressures. Moreover, in collaboration with research conducted in the financial system function, we continue to explore underlying trends in household imbalances and the Canadian housing market and their implications for household credit.

Another research goal is to better understand how international developments affect the Canadian economy and the context they provide for the conduct of monetary policy. This work includes (i) analyzing the transmission and international spillover effects of macroeconomic policies, such as the introduction and withdrawal of unconventional monetary policy measures by central banks; (ii) enhancing our understanding and modelling of emerging-market economies and their influence on the global and Canadian economies, as well as on commodity prices; (iii) analyzing developments in commodity markets, especially technological progress in the energy sector; (iv) gaining a better understanding of some of the key forces that are shaping the structure of the global economy (e.g., trade, offshoring and globally integrated value chains); and (v) improving our understanding of how Canadian financial markets are affected by changes in global bond yields and other asset prices. We also continue to analyze the international monetary system (particularly how the rebalancing of global demand is evolving), reserve accumulation and sterilization, capital flows, exchange rate adjustment, and the role of the International Monetary Fund.

Financial System

An efficient and stable financial system is critical to the long-run stability and growth of the Canadian economy. The Bank thus has a strong interest in minimizing systemic vulnerabilities and promoting the efficiency of Canada’s financial system. Research in this area aims to deepen our understanding of the behaviour of financial institutions and the evolving role within the financial system of complex financial instruments, institutions, infrastructures and markets.

Since the financial crisis, financial regulatory, supervisory and resolution frameworks have undergone sweeping global reforms. A research priority of the Bank is to evaluate the impact and effectiveness of such reforms and analyze the evolution of the financial system in response to regulatory changes and market-led initiatives. This work includes (i) evaluating the impact and effectiveness of micro- and macroprudential policy tools, such as higher capital, liquidity and leverage standards, the countercyclical adjustment of capital requirements (countercyclical capital buffer), and changes to mortgage policies related to housing finance; (ii) exploring the optimal design and degree of complexity of regulations for banking sector capital; (iii) analyzing the implications of financial reforms for financial intermediation outside the traditional banking sector; and (iv) assessing the impact of capital and liquidity regulations on the functioning of Canadian financial markets. We are also analyzing ongoing developments in Government of Canada repo, securities-lending and cash markets to inform broad policy questions related to the functioning of those markets, monetary policy implementation, and the Government of Canada’s debt-issuance strategy and yield curve. This research will also help the Bank to understand the effect of innovations and developments in market structure (such as changes in trading technology and transparency) on financial system efficiency and stability.

Another research priority is to better understand how vulnerabilities and risks emerge in the financial system. Part of this research centres on developing a comprehensive quantitative framework for monitoring vulnerabilities and assessing systemic risks. This work includes enhancing and integrating the relevant analytical models, such as early-warning models, models of sectoral vulnerability and macro stress-testing models. Bank researchers also continue to investigate the nature of liquidity, credit risk and foreign exchange risk. In the context of international experience with negative interest rates, and in collaboration with the research conducted in the monetary policy function, we are assessing the implications of potential negative interest rates on market functioning and on banks and shadow banking in Canada. Another area of interest is to extend our understanding of how mortgage lending activity and housing prices affect household indebtedness and financial system vulnerabilities; this research is also conducted in collaboration with the monetary policy function.

One of the Bank’s goals is to support regulatory and technological changes that strengthen Canada’s financial market infrastructures (FMIs). Our research will help guide the implementation of oversight standards for designated payment clearing and settlement systems, inform the development of a resolution framework for FMIs, and support the modernization of Canada’s core payment systems.

Currency

To support its objective of supplying Canadians with bank notes that they can use with confidence, the Bank undertakes economic and technology research on issues related to the national currency.

The major theme of our economic research in 2015 is to improve our understanding of the likely evolution of the demand for bank notes, given the changes in the retail payments landscape. Our research focus is on understanding how consumers choose between various means of payment and calculating the total costs of those payment options. We are also studying developments in digital currencies and their implications for both the demand for bank notes and central bank policies related to financial stability and monetary policy. In addition, we are examining the potential roles of the Bank with respect to oversight and issuance of e-money.

With the issuance of the Polymer series of bank notes completed in 2013, the current focus of our technology research is to identify and develop new security features for future bank notes and to update contingency options to address emerging counterfeiting threats. We are also enhancing our ability to collect data across the entire life cycle of a bank note, from production through distribution to destruction, to better characterize the performance and flow of bank notes in circulation. Operational research is also under way to optimize our cash-processing model at our two agency operations centres.

Funds Management and Banking

As fiscal agent for the Government of Canada, the Bank oversees the funding and management of Canada’s foreign exchange reserves and the federal wholesale and retail debt programs. The objective of our research is to provide effective policy advice related to these activities in order to optimize the trade-offs between cost (or return) and risk. Another focus is the promotion of safer and more efficient payment clearing and settlement systems.

Our first priority is to improve our knowledge of the risk and efficiency trade-offs in Canadian payment clearing and settlement systems, consistent with our financial stability role. This involves working on a fundamental review of the payment system infrastructure with the Canadian Payments Association and continuing to deepen our understanding of the implications of recent innovations in retail payments for both the Bank and the economy.

The second research objective is to investigate questions related to the optimal level of public debt in an environment in which debt securities have important alternative uses apart from simply financing the government. For example, the use of Government of Canada securities as collateral to satisfy new post-crisis regulatory requirements could influence debt-issuance decisions, especially if the government’s financing requirements begin to decline.