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explainer

The Bank of Canada in Ottawa on July 12.Sean Kilpatrick/The Canadian Press

What is the Bank of Canada?

The Bank of Canada is a Crown corporation and financial institution that sits at the heart of the Canadian economy. Located in Ottawa, the central bank is responsible for producing banknotes and conducting monetary policy: setting interest rates, stabilizing the value of the Canadian dollar, and supporting the economy through downturns. It is also the banker for the government, managing its public debt programs and foreign-exchange reserves, and it works with other financial regulators to ensure the banking system is stable.

Why do we need a central bank, anyway?

The Bank of Canada’s main goal is to protect the purchasing power of the Canadian dollar. That means keeping inflation – the speed at which consumer prices rise – low and stable, at around 2 per cent each year. It judges inflation based on the consumer price index, or CPI, produced by Statistics Canada, which tracks price changes across a representative basket of goods and services.

In the past, the value of money was tied to gold in bank vaults. Later, the Canadian dollar became fixed to the U.S. dollar, which in turn was pegged to gold. This global currency system collapsed in the 1970s, forcing central banks to come up with other ways of anchoring the value of their money. In the 1990s, the Canadian central bank began “inflation targeting” – that is, setting interest rates with the goal of keeping the annual rate of CPI inflation at around 2 per cent.

The Bank of Canada also acts as a “lender of last resort” to financial institutions in the event of a financial panic or bank run. It can do this because of its ability to create money with the click of a button. It was acting in this capacity in March, 2020, when it pumped billions of dollars of cash into the financial system to prevent Canada’s credit markets from seizing as the economy went into lockdown.

What is happening to inflation?

Canada is experiencing the first inflation surge in a generation. Annual CPI growth hit a four-decade high of 8.1 per cent in June. It has since fallen to 6.9 per cent in September. While headline inflation is declining, price increases are broadening. Nearly 80 per cent of goods and services in the CPI basket had annual price increases of more than 3 per cent in September.

The drivers of inflation have evolved over the past two years. Inflation began to rise in the spring of 2021 as surging demand for goods ran into supply constraints caused by the COVID-19 pandemic. These included factory shutdowns, shipping bottlenecks and labour shortages.

At the same time, demand was fueled by ultra-low interest rates and unprecedented government support for households and businesses, which more than made up for lost income from pandemic-related shutdowns. Central banks and governments around the world have been criticized for acting too slowly to remove fiscal and monetary stimulus as inflation began to rise last year. Russia’s invasion of Ukraine this spring added to the problem by causing a huge spike in energy and food prices.

Inflation is increasingly being driven by domestic factors. These include a rebound in demand for in-person services after the end of pandemic restrictions, and a tight labour market. Companies are raising wages to compete for scarce workers, and workers are demanding higher wages to keep up with inflation. Higher wages feed into inflation, as companies look to cover their costs by raising prices further.

How does the bank control inflation?

The Bank of Canada controls inflation by influencing demand in the economy. It can’t do much to bring down global commodity prices or fix supply chain issues, but it can moderate demand for goods, services and housing by adjusting borrowing costs. When the economy is running hot and prices are rising too quickly, the bank raises interest rates to lower demand. The reverse is true during an economic downturn, when the bank cuts interest rates to stimulate demand and boost inflation.

In practice, the central bank changes interest rates primarily by adjusting its policy rate: the short-term interest rate that determines how much commercial banks pay for overnight loans. Changes in the policy rate reverberate through the economy, affecting interest rates on mortgages, government bonds and business loans.

The bank can also influence rates by communicating with financial markets, and by buying huge amounts of government bonds from investors – a practice known as quantitative easing, or QE. The Bank of Canada used QE for first time during the pandemic, buying more than $300-billion worth of government bonds.

The bank kept interest rates at record lows during the first two years of the pandemic, holding the policy rate at 0.25 per cent. It ended its QE program last fall, then started raising its policy rate this spring. It has raised rates five times since March, bringing the policy rate up to 3.25 per cent in one of the fastest rate-hike campaigns on record. Analysts expect the bank to announce another large rate hike on Wednesday.

How do rising interest rates affect average Canadians?

When interest rates rise, borrowing becomes more expensive. Most Canadians experience interest rates through mortgages, and through various forms of consumer debt, including credit cards, personal loans and auto loans.

Commercial banks have pushed mortgage rates sharply higher in response to moves by the Bank of Canada. The prime rate, which banks use to calculate interest rates on variable rate mortgages and home-equity lines of credit, has risen to 5.45 per cent, from 2.45 per cent in 2021. Interest rates for fixed-rate mortgages have also risen.

Canadians with fixed-rate mortgages will feel higher rates when they renew. People with variable-rate mortgages could see their costs rise sooner. Economists at Toronto-Dominion Bank estimate that by the end of 2023, total household debt servicing costs will be around 30 per cent higher than at the start of 2022, with the average borrower spending an extra $2,500 a year.

More broadly, higher interest rates will slow down the economy and increase unemployment. The most visible impact so far is in the housing market. Home sales fell 32 per cent in September compared to the previous year, while the Canadian Real Estate Association’s benchmark home price index is down 7.4 per cent since the peak in February. Both consumer and business sentiment has soured in recent months, and a growing number of private-sector economists expect the Canadian economy to enter a recession in 2023.

Bank of Canada governor Tiff Macklem speaks at a news conference in Ottawa on June 9.PATRICK DOYLE/The Canadian Press

Who’s in charge of all this?

The Bank of Canada is led by a governor, who is appointed by the federal government and serves a seven-year term. The current governor, Tiff Macklem, started his term in June, 2020. Second-in-command is senior deputy governor Carolyn Rogers, who began her term in December, 2021.

The bank is overseen by a board made up of the governor, the senior deputy governor, and 12 independent members who are each appointed for three years. Deputy minister of finance Michael Sabia also sits on the board as a non-voting member.

Monetary policy decisions are made by a separate six-member governing council, made up of Mr. Macklem, Ms. Rogers and four other deputy governors. They meet every six to eight weeks to decide on interest rates and other monetary policy matters. These decisions are announced publicly, setting the tone for Canada’s financial markets.

How much power does the government have over the Bank of Canada?

The Bank of Canada operates independently from government on a day-to-day basis, although Ottawa does set the bank’s overall monetary policy goals every five years. The principle of central bank independence is a cornerstone of Canada’s economic and financial system. The approach is based on the idea that controlling inflation sometimes requires hard decisions that politicians are unlikely to make, such as raising interest rates to cool the economy.

While the minister of finance has the power to direct a central bank governor in the event of a major disagreement about monetary policy, that power has never been used. The government is required to publish the directive, which most analysts believe would result in the immediate resignation of the governor and trigger a political crisis.

No government has ever formally removed a central bank governor, but there is one example of a prime minister effectively forcing a governor to resign. In 1961, prime minister John Diefenbaker had a public falling out with governor James Coyne over disagreements about monetary and economic policy. Mr. Diefenbaker tried to fire the governor by getting Parliament to declare his position vacant. The Senate shot down the move, but Mr. Coyne subsequently resigned.