How vulnerabilities like debt can affect interest rates

Deputy Governor Paul Beaudry explains to students at Laval University why financial vulnerabilities—such as household debt—are important for the Bank of Canada when it sets interest rates.

Financial factors in focus

The Bank works hard to understand how financial factors affect the economy. We need to understand how much Canadians are borrowing and lending and how that affects our interest rate policy. High household debt is the economy’s most important vulnerability.

Policy that’s right today may not be right later on

Financial vulnerabilities are particularly tricky for a central bank. For one thing, they can change the impact of interest rates on the economy over time. Lowering interest rates can boost the economy in the short term. But it can also encourage people to take on more and more debt. And this vulnerability can become a drag on the economy later on. Put another way, vulnerabilities can lead to a trade-off that central bankers need to think about.

The trade-off in action

We faced this trade-off in our interest rate decision last October. The global economy was looking weak. The Bank knew there was a risk this would slow our economy and pull inflation below our target. We considered an interest rate cut as “insurance” to support the economy. But we also knew that lowering interest rates could spark a boom in borrowing—especially for houses—and an additional buildup of debt. And we saw that this increased debt could slow our economy and make it harder to hit our inflation target in the future. So, we decided that the short-term benefit to the economy was not worth the potential cost in the long run.

Figuring out the trade-off using “growth at risk”

We use a “growth-at-risk” framework to help us measure the trade-off. This tool lets us compare, for example, how much extra growth an interest rate cut could generate with how much growth could be at risk because of vulnerabilities. Staff are working on other ways to help us analyze this trade-off.

Inflation control is still Job One for monetary policy

Inflation control remains the prime mission of our monetary policy. That’s because keeping inflation low, stable and predictable is the best way we can contribute to Canada’s economic welfare. It’s important to look at vulnerabilities because they can make it more challenging to meet our inflation goals. And while monetary policy can help address financial vulnerabilities, we know that other policies designed to make the financial system safer—macroprudential policies—are the economy’s first line of defence.