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The Transmission Mechanism and the Effectiveness of Monetary Policy Actions

Statement by Mark Carney, Governor of the Bank of Canada to the Standing Senate Committee on Banking, Trade and Commerce

Mr. Chairman, the sharp movement and wide swings in interest rate spreads that we have witnessed since the onset of the recent financial market turbulence have prompted many analysts to question whether monetary policy remains effective in controlling inflation. The short answer is yes. Allow me to take a few minutes to explain why this is the case.

The Bank of Canada's policy objective is a 2 per cent target for total consumer price inflation. The tool we use to achieve our policy objective is the overnight interest rate – the rate at which major financial institutions borrow and lend funds for one day, or "overnight," among themselves. We set a target for the overnight rate and can achieve that target through our ability, using our balance sheet, to supply overnight funds.

When the Bank of Canada changes its target for the overnight rate, it sets in motion a complex chain of consequences that first influences prices in financial markets, and then affects spending, production and employment and, ultimately, inflation. Economists call this chain of developments the transmission mechanism. My focus here is on the first link in that chain.

With a change in the overnight rate, other interest rates along the maturity spectrum tend to change. Intuitively, this makes sense. If the cost to borrow money for a 1-day period becomes cheaper or more expensive, and this change is expected to persist, the cost to borrow money for a 30-day period, a 90-day period, a 1-year period, et cetera, should also change. In addition, administered interest rates such as the prime lending rate, and the prices of many other financial assets, including the value of the Canadian dollar and equity prices, are affected.

Thus, all else being equal, a change in the overnight rate of interest which is expected to persist will influence the overall level of short- to longer-term interest rates, and the prices of many other financial assets. But typically, all else is not equal and the situation we face today, with a fundamental repricing of risk taking place, is a good example.

Interest rates on various financial obligations include a risk premium that reflects the creditworthiness of borrowers and the degree of liquidity of the financial instrument. Corporate bonds, whether issued by financial or non-financial firms, carry a rate of interest that incorporates both of these considerations. Lending institutions, such as banks, set their lending rates on the basis of their cost of funds and on the creditworthiness of their customers.

Risk premiums (or credit spreads, as they are often called) are market determined. Any widening or narrowing of risk premiums is not something monetary policy can influence. But monetary policy can, and does, take into account these movements in risk premiums by influencing the overall level of interest rates through changes in the target for the overnight rate of interest.

Let me give you an example using the circumstances we face today. Because of heightened uncertainty in global financial markets and widening risk premiums, the cost of raising funds has increased for Canadian banks. These higher costs are being passed on to corporate and household borrowers. Less creditworthy borrowers are also facing higher credit premiums in the rates at which they can borrow from banks. But this does not necessarily mean that the absolute cost of corporate and household borrowing has risen.

The reason is that the Bank of Canada can factor in these movements in risk premiums, or credit spreads, when setting the target for the overnight rate at a level that is judged to be appropriate for achieving our 2 per cent inflation target. Such judgment led the Bank to lower its target overnight rate by 150 basis points since last December.

In summary, Mr. Chairman, the key point I am trying to convey is the difference between interest rate spreads and the absolute level of interest rates. The former is determined in competitive financial markets. The latter is what monetary policy can and does effectively influence. Recent developments have not altered this fact.