Understanding how monetary policy works

It takes time for our policy decisions to filter—or be transmitted—through the economy and financial system.

Four transmission channels

When we adjust our policy interest rate at the Bank, we don’t expect immediate results. It usually takes 18 to 24 months to see the full effects. Interest rate changes affect the economy through four main channels:

• commercial interest rates—what you pay on mortgages and loans and what you receive on deposits
• the Canadian dollar exchange rate
• people’s expectations for inflation
• the prices of assets such as houses, stocks and bonds

Commercial interest rates

Changes in our policy interest rate influence commercial interest rates.

• Lower commercial interest rates mean people and businesses pay lower interest on loans and mortgages and earn less interest on savings. When rates are lower, people tend to spend more, boosting the economy and inflation.
• Higher commercial interest rates mean people and businesses pay higher interest on loans and mortgages. This discourages them from borrowing and spending and puts the brakes on the economy and inflation.

Generally, financial institutions don’t match those interest rate changes exactly, except for loans tied to their prime rate—for example, variable-rate mortgages.

Other factors also affect commercial lending rates. These include:

• costs for lenders to raise capital
• competition among lenders
• lenders’ perceptions of how risky it is to lend to individual borrowers

Exchange rate

The level of our interest rates compared with those in other countries affects the exchange rate of our currency.

A drop in Canadian interest rates may lead to a weaker Canadian dollar. Over time, this can:

• make the prices for imported goods and services more expensive in Canada
• lower the prices for Canadian-made products abroad, making them more attractive in foreign markets

The combined effect can lead to faster inflation in Canada.

By contrast, a rise in Canadian interest rates may lead to a stronger Canadian dollar. Over time, this can:

• make the prices for imported goods and services cheaper in Canada
• raise the prices for Canadian-made products abroad, making them less attractive in foreign markets

The combined effect can lead to slower inflation in Canada.

Expectations

Businesses and households make decisions about what to buy, where to invest and how much to save. They base their decisions in part on their expectations for future inflation.

If people expect prices to rise:

• they may consume more now before prices go up
• they may demand more in wages to keep up with expected higher prices

If people expect prices to fall:

• they may consume less now while they wait for lower prices
• they may not feel the need to demand higher wages

If we raise our policy interest rate, people might expect inflation to fall. If we lower it, people might expect inflation to rise. We focus a lot of our communications on helping Canadians better understand inflation because their expectations can influence the rise or fall of inflation.

Asset prices

When interest rates go up, investors may expect the demand for goods and services to fall. If demand falls, companies make less money. If investors anticipate that companies will make less money, the price of assets, such as stocks and bonds, drops. People who hold these assets would therefore feel less wealthy and may be less likely to borrow and spend. This can lead to lower inflation.

But when interest rates go down, investors may expect companies’ future earnings to grow. The price of stocks and bonds increases as a result. In turn, people may feel wealthier and increase their:

• borrowing
• spending
• demand for goods and services

This would lead to higher inflation.

The role of supply and demand

These four channels work together to affect the demand for goods and services. This, in turn, affects the balance of supply and demand in the economy, which leads to changes in the level of inflation.

How much each channel responds to interest rate changes may vary over time. The exchange rate may respond right away, but it takes longer before these changes affect spending and saving—and even longer before they affect inflation. That is why we make monetary policy decisions with a view to the future, understanding that we can’t always predict what’s to come.