Transmission in Monetary Policy

THE BANK OF CANADA CARRIES OUT monetary policy with the aim of protecting the value of Canadian money by keeping inflation low and stable.

Monetary policy is implemented mainly through changes in the Target for the Overnight Rate which influence other interest rates and affect the level of spending and economic activity in the country.

But changes to the Bank Rate do not immediately affect the economy in a manner that is readily predictable. The transmission mechanism of monetary policy has long and variable lags because the economy takes time to adjust to changes in monetary conditions.

Time lag is 18 to 24 months

Interest rate changes can take from 18 to 24 months to work their way through the economy and have a significant effect on inflation. A dynamic process of adjustment takes place in the economy in the following stages:

• changes in interest rates lead to changes in spending and sales;
• changes in spending and sales lead to changes in production (and employment); and
• changes in production lead to changes in prices and, thus, to changes in inflation.

Each of these stages lags behind the previous one, and the length of the lags can vary. Because the effect of monetary policy actions on prices can have a long lag, the Bank of Canada must recognize, as early as possible, any signals that indicate the emergence of upward or downward pressure on prices down the road and take corrective measures well in advance of the time the impact of these pressures will be felt.

Bank adjusts monetary conditions

If the Bank estimates that the economy will be exceeding its capacity at some point in the future, the Bank may need to adjust monetary conditions ahead of time in order to prevent inflation pressures from building. Conversely, if the economy was expected to slow down, the Bank would take action to ease monetary conditions (by lowering interest rates) so that inflation would not fall below the target range.

Various economic indicators are used to judge what inflation is likely to be 18 to 24 months in the future. These include the intensity of credit demand, the pace of monetary expansion, and developments in prices and costs.

Timely, measured steps are necessary to ensure that the economy can grow on a sustainable basis--that is, without generating inflation pressures.

Because of the lag, monetary policy must focus on the future, rather than the present. By always acting in a forward-looking manner, the Bank of Canada aims to pre-empt future inflation and keep it within its inflation-control target range.

July 2001