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explainer

FILE PHOTO: A sign is pictured outside the Bank of Canada building in Ottawa, Ontario, Canada, May 23, 2017. REUTERS/Chris Wattie/File PhotoCHRIS WATTIE/Reuters

The Bank of Canada has been criticized in recent months over runaway inflation, most prominently by Conservative Party leadership candidate Pierre Poilievre, who tweeted in April that the institution is financially illiterate. At Wednesday’s Conservative leadership debate, Mr. Poilievre said that, if he forms government, he would remove the Bank of Canada’s Governor, Tiff Macklem.

The following day, Prime Minister Justin Trudeau took Mr. Poilievre to task for jeopardizing the Bank of Canada’s independence, adding that he seems to “either misunderstand that or not care about the facts at all.”

So what does the Bank of Canada do exactly, who runs it and how does that affect average Canadians? Here’s a breakdown.

What is the Bank of Canada and where is it located?

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 in charge of banknotes – in other words, Canadian cash – and 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.

In the past, the value of money was tied to the amount of 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 BoC began “inflation targeting” – that is, setting monetary policy with the goal of keeping 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 unique ability to create money out of thin air. 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?

Over the past year, inflation has run well above the central bank’s target, hitting a three-decade high of 6.7 per cent in March. There’s considerable debate about the causes of this inflation, but most economists agree that it’s due to a combination of supply-chain blockages caused by COVID-19, a surge in consumer demand for durable goods instead of services during pandemic lockdowns, super low interest rates, and massive government support for businesses and households during the pandemic. More recently, Russia’s invasion of Ukraine has sent commodity prices soaring, squeezing people at the gas pump and grocery store.

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.

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. This short-term rate influences other interest rates in the economy. The bank can also influence rates by communicating with financial markets and buying huge amounts of government bonds from investors – a practice known as quantitative easing (QE). The BoC used QE for first time during the pandemic, buying more than $300-billion worth of government bonds. Mr. Poilievre’s criticism of the BoC revolves largely around its use of QE.

The bank kept interest rates at record lows during the first two years of the pandemic to support the economy. Both economic output and employment have since recovered, and the economy is now overheating, adding to inflationary pressures. The bank pivoted in March and began raising its benchmark interest rate. It has raised the rate twice – including an oversized half-percentage-point increase in April – and indicated that more rate hikes are on the way. This amounts to the fastest interest rate hike cycle in decades.

The benchmark rate is currently at 1 per cent, and Bank of Canada officials have said they intend to get it back to between 2 and 3 per cent relatively quickly.

How will 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 already begun pushing mortgage rates 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 3.2 per cent, from 2.45 per cent in 2021. Interest rates for fixed-rate mortgages have also risen.

The majority of Canadian homeowners have fixed-rate mortgages, which means they won’t feel higher rates until they renew. Likewise, many variable-rate mortgages have fixed payments, which means mortgage-holders won’t face a sudden jump in monthly expenses as the prime rate increases. However, they’ll have to pay more in interest and less toward principal each month.

The largest impacts of interest rate increases tend to be on the real estate sector of the economy, and the bank expects higher borrowing costs to take some of the fuel out of Canada’s housing market. There are some signs that Canada’s hottest housing markets have already begun to cool. Home sales in Toronto dropped 27 per cent in April compared to the previous month, and an index that measures home prices in the city showed the first monthly decline since October 2020.

The BoC will be watching the housing market closely as it raises rates. How high and how fast it moves could depend on the stability of the housing market.

Who’s in charge of all this?

The bank is led by a governor, who is appointed by the 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 seven-member governing council, made up of Mr. Macklem, Ms. Rogers and five 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 then-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.

With a report from Matt Lundy

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