The financial crisis of 2007–09 has highlighted the importance of developments in financial conditions for real economic activity. The authors estimate the effect of current and past shocks to financial variables on U.S. GDP growth by constructing two growthbased financial conditions indexes (FCIs) that measure the contribution to quarterly (annualized) GDP growth from financial conditions.Topics: Business fluctuations and cycles; Monetary and financial indicators; Monetary conditions index; Recent economic and financial developments
The household debt-to-disposable income ratio in Canada increased from 110 per cent in 1999 to 127 per cent in 2007. This increase has raised questions about the ability of households to service their increased debt if faced with a negative economic or socio-economic shock.Topics: Financial stability; Monetary and financial indicators
The Bank of Canada maintains regular contact with financial institutions as part of the information-gathering process that feeds into the larger set of information used to arrive at its monetary policy decision. Since 1999, the Bank has been conducting a quarterly survey of the business-lending practices of major Canadian financial institutions. Analysis of the information collected shows that it is correlated with future growth in both credit and business investment. This article focuses on how the survey is conducted and describes the construction of the summary statistics, highlighting the key statistical relationships in the historical survey data.Topics: Financial Institutions; Monetary and financial indicators; Recent economic and financial developments
The authors examine simultaneously the causal links connecting monetary policy variables, real activity, and stock returns.Topics: Monetary and financial indicators
An effective exchange rate is a measure of the value of a country's currency vis-à-vis the currencies of its most important trading partners. The Bank of Canada has created a new Canadian-dollar effective exchange rate index (CERI) to replace the C-6 index that it currently uses. The CERI uses multilateral trade weights published by the International Monetary Fund and includes the six currencies of countries or economic zones with the largest share of Canada's international trade. As such, it better reflects the recent changes in Canada's trade profile, including the rise in the importance of China and Mexico and the relative decline in importance of Europe and Japan in Canada's international trade. The author describes the methodology and construction of the new index and reviews the advantages it offers over the C-6, particularly the use of multilateral trade weights, the inclusion of trade in services, and the use of more recent trade data.Topics: Exchange rates; Financial markets; Monetary and financial indicators
Although many countries have abandoned monetary targeting in recent decades, monetary aggregates are still useful indicators of future economic activity. Past research has shown that, compared with other monetary aggregates and expressed in real terms, net M1 and gross M1 have traditionally provided superior leading information for output growth. Yet financial innovations and the elimination of reserve requirements over the past two decades have made it increasingly difficult for financial institutions to differentiate between demand and notice deposits, suggesting the need to re-examine the information content of narrow monetary aggregates that depend on such a distinction. Based on an analysis over a sample period from 1975Q1 to 2005Q1, the authors determine that the leading-indicator properties of the narrow monetary aggregates for output growth have shifted over time and that, since 1993, real M1+ has become a better indicator of future output growth than real gross and net M1.Topics: Monetary aggregates; Monetary and financial indicators
The issue addressed in this article is the extent to which monetary policy in Canada should respond to asset-price bubbles. The article concludes that maintaining low and stable consumer price inflation is the best contribution that monetary policy can make to promoting economic and financial stability, even when the economy experiences asset-price bubbles. In extreme circumstances—when an asset-price bubble is well identified and likely to have significant costs to the economy when it bursts—monetary policy might better maintain low and stable consumer price inflation by leaning against a particular bubble even though it may mean that inflation deviates temporarily from its target. Such a strategy might reduce the risk that a crash in asset prices could lead to a recession and to inflation markedly below target in the longer run. The circumstances where this strategy is possible will be rare because economists are far from being able to determine consistently and reliably when leaning against a particular bubble is likely to do more harm than good. Housing-price bubbles should be a greater concern for Canadian monetary policy than equity-price bubbles, since rising housing prices are more likely to reflect excessively easy domestic credit conditions than are equity prices, which are largely determined in global markets.Topics: Inflation targets; Monetary and financial indicators; Monetary policy framework
The authors construct three financial conditions indexes (FCIs) for Canada based on three approaches: an IS-curve-based model, generalized impulse-response functions, and factor analysis.Topics: Monetary and financial indicators; Monetary conditions index
Technological innovations in the financial industry pose major problems for the measurement of monetary aggregates. The authors describe work on a new measure of money that has a more satisfactory means of identifying and removing the effects of financial innovations.Topics: Econometric and statistical methods; Monetary aggregates; Monetary and financial indicators
This paper shows that if the Bank of Canada is optimally adjusting its monetary policy instrument in response to inflation indicators to target 2 per cent inflation at a two-year horizon, then deviations of inflation from 2 per cent represent the Bank's forecast errors, and should be uncorrelated with its information set, which includes two-year lagged values of the instrument and the indicators. Positive or negative correlations are evidence of systematic errors in monetary policy.Topics: Inflation targets; Monetary and financial indicators; Monetary policy implementation
This article outlines one of the Bank's key approaches to dealing with the uncertainty that surrounds decisions on monetary policy: the consideration of a wide range of information from a variety of sources. More specifically, it describes the information and analysis that the monetary policy decision-makers—the Governing Council of the Bank of Canada—receive in the two or three weeks leading up to a decision on the setting of the policy rate—the target overnight interest rate. The article also describes how the Governing Council reaches this decision.Topics: Monetary and financial indicators; Monetary policy framework; Monetary policy implementation
This paper examines the predictive power of credit spreads from the corporate bond market. The high-yield bond spread and investment-grade spread can explain 68 per cent and 42 per cent of output variations one year ahead, while the term spread based on government debts can explain only 12 per cent of them.Topics: Financial markets; Monetary and financial indicators; Transmission of monetary policy
Financial and monetary variables have long been known to contain useful leading information regarding economic activity. In this paper, the authors wish to determine whether the forecasting performance of such variables can be improved using neural network models. The main findings are that, at the 1-quarter forecasting horizon, neural networks yield no significant forecast improvements. [...]Topics: Econometric and statistical methods; Monetary and financial indicators
In this article, the authors identify forward rate agreements, or FRAs, as short-term interest rate guarantee instruments negotiated by two parties, one of which is typically a bank. In outlining the main features of FRAs, the authors contrast them with BAX contracts (futures contracts on bankers' acceptances that are negotiated through the Montreal Exchange). The article then describes how market participants use FRAs to cover short-term interest rate risk. The final section deals with the way the Bank of Canada uses information from the FRA market as an indicator of interest rate expectations.
Econometric models used to retrieve information from FRA rates, as well as the underlying assumptions, are discussed in an appendix.Topics: Financial markets; Monetary and financial indicators
This paper examines the relationship between the term structure of interest rates and future changes in inflation for Canada using a newly constructed par-value yield series. The main conclusion of the empirical work is that the slope of the nominal term structure from 1- to 5-year maturities is a reasonably good predictor of future changes in inflation over these horizons.Topics: Interest rates; Monetary and financial indicators
In this paper two shocks are analysed using Canadian data: a money-supply shock ("M-shock") and an interest-rate shock ("R-shock"). Money-supply shocks are derived using long-run restrictions based on long-run propositions of monetary theory. Thus, an M-shock is represented by an orthogonalized innovation in the trend shared by money and prices.Topics: Monetary and financial indicators; Transmission of monetary policy
The authors examine the Bank of Canada's overnight rate as a measure of monetary policy in vector autoregression (VAR) models. Since the time series of the Bank's current measure of the overnight rate begins only in 1971, the authors splice it to day loan rate observations to obtain a sufficiently long period of data.Topics: Economic models; Monetary and financial indicators
This paper examines the empirical performance of alternatives to the monetary aggregates currently published by the Bank of Canada. The results show that real M1 and real M1a perform about equally well in providing leading information about real output at short horizons. However, on theoretical grounds, M1a is a more attractive aggregate, since it excludes [...]Topics: Monetary and financial indicators
The spread between long-term and short-term interest rates has proven to be an excellent predictor of changes of economic activity in Canada. As a general rule, when long-term interest rates have been much above short-term rates, strong increases in output have followed within about a year; however, whenever the yield curve has been inverted for any extended period of time, a recession has followed.
Similar findings exist for other countries, including the United States. But although Canadian and U.S. interest rates generally move quite closely together, the Canadian yield curve has been distinctly better at predicting future Canadian output.
The explanation given for this result is that the term spread has reflected both current monetary conditions, which affect short-term interest rates, and expected real returns on investment and expectations of inflation, which are the main determinants of long-term rates.
This article is mainly a summary of econometric work done at the Bank. It also touches on some of the extensive recent literature in this area.Topics: Interest rates; Monetary and financial indicators
This paper examines the predictive content of the term structure of interest rates for economic activity in Canada. Recent papers for the United States and other countries find that the slope of the term structure is a very good predictor of output growth.Topics: Interest rates; Monetary and financial indicators