Canada's Approach to Monetary Policy

By Little, Jane Sneddon | New England Economic Review, Spring 2002 | Go to article overview
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Canada's Approach to Monetary Policy

Little, Jane Sneddon, New England Economic Review

The ultimate goal of Canadian monetary policy is maintaining a low, stable rate of inflation in order to foster efficient economic performance and a rising standard of living for Canadians. More specifically, the Bank of Canada (1) aims to keep inflation inside a target range of 1 to 3 percent. This range, established jointly with the federal government, was first announced in 1991 and has been extended through the end of 2006. Over the medium term, the target applies to total CPI. The Bank also uses a core CPI measure as a guide to future inflation developments over the shorter term. The Bank of Canada's operational target is the overnight rate, which is set at the midpoint of a 50 basis point operating band. (2)

Central Bank Assets

At the end of 2000 the Bank of Canada had Can$40 billion in assets, the bulk (83 percent) of which were investments in securities issued or guaranteed by the Government of Canada, which are generally held to maturity. Other investments (4 percent) were largely composed of foreign currency investments acquired in short-term swap arrangements with the government's Exchange Fund Account. In addition, the Bank's assets included deposits in foreign currencies (2 percent), advances to members of the Canadian Payment Association (2 percent), and "other assets" (9 percent), the bulk of which were Government of Canada securities purchased under resale agreements.

Standing Facilities

The advent of the Large Value Transfer System (LVTS), the Canadian Payments Association's new electronic payments system, which became fully operational in February 1999, resulted in some changes in the Bank's operating procedures. (3) The Bank sets a target for the overnight interest rate at the midpoint of its 50 basis point operating band. LVTS participants needing an overdraft (fully collateralized, as discussed below) at the day's final settlement are charged the Bank rate, the upper limit of the operating band. The Bank pays an interest rate equal to the lower limit of the band on positive balances remaining after the LVTS settlement. The Bank typically sets the level of settlement balances in the financial system at a slight positive value. (4) Thus, LVTS participants with deficits know that potential counterparties with surplus funds exist. After the close of client business at 6 p.m., participants have one-half hour to trade with each other to reduce their LVTS positions through transactions made at market rates. (5)

Open Market Operations

The Bank announces any change in the target rate and operating band at 9 a.m. If necessary, the Bank will intervene in the open market at about 11:45 a.m. if the overnight rate is straying from its target in the midpoint of the band. It uses Special Purchase and Resale Agreements (SPRAs) with a term of one business day if the overnight rate is too high and Sale and Repurchase Agreements (SRAs) if the rate is too low. (6) These repo and reverse repo-type transactions are based on Government of Canada securities, which are marked to market and subject to haircuts that rise with the maturity of the security to as much as 2.5 percent. The counterparties in these operations are the primary dealers, each of which has a predetermined limit for both types of transactions. The primary dealers are a group of government securities distributors who maintain a minimum share of the activity in the market for Canadian government debt. (Prior to the start of the LVTS, SPRAs and SRAs were used to reinforce the upper and lower limits of the band.)

Auctions of Government Deposits

To keep the settlement balances in the financial system slightly positive, the Bank neutralizes the impact of any public sector flows between the Bank of Canada and the financial system. It does so by transferring government deposits to and from the government's account at the Bank of Canada. The transfer occurs through two daily auctions--at 9:15 a.

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