Constraints on the Conduct of Canadian Monetary Policy in the 1990s: Dealing with Uncertainty in Financial Markets

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Canada's economic performance in the first half of the 1990s was adversely affected by high premiums in interest rates that were brought on by political and economic uncertainties. The short-term output-inflation trade-off was worsened since these uncertainties weakened the value of the Canadian dollar at the same time as they raised domestic interest rates. In this environment, attempts by the Bank of Canada to ease monetary conditions were liable to be misinterpreted by the market as a sign of weakening commitment to inflation control. On several occasions, such fears led to sharp increases in interest rates.

The first part of this report presents a simple theoretical model that shows the qualitative impact of the increased interest rate premiums on economic performance. Some evidence is presented that suggests high Canadian interest rate premiums were an important factor explaining the general weakness of economic activity. This is followed by a discussion of the tactical conduct of monetary policy when the need to build credibility often seemed to be in conflict with the desired easing of monetary conditions. Finally, the report describes steps that the Bank has taken to reduce uncertainty about how it conducts monetary policy.