Monetary policy
Now let's turn to monetary policy.Important as they are, bank notes account for only a small part of the broader money supply in our economy. Preserving confidence in Canadian money more generally is the focus of the Bank's monetary policy. Of course, preserving confidence in money depends on preserving the value of money itself. And, in turn, preserving the value of money depends on keeping inflation low, stable, and predictable.
Most of the continuing attention paid to the Bank of Canada by the media, the business community, and financial markets is focused on our efforts to keep inflation under control. Occasionally, this objective is misunderstood as something that the Bank pursues as an end in itself. That is just not so. The reason we insist on keeping inflation in line is because this is the best contribution the Bank can make to a healthy economy.
Keeping inflation low, stable, and predictable is essential to keeping the economy on the smoothest possible track for long-lasting economic growth and job creation. In this way, monetary policy aims to avoid inflationary "boom-and-bust" cycles that lead to painful recessions and rising unemployment. To put it another way, the Bank's focus on inflation means that the gap between the potential and actual performance of the economy can be kept as narrow as possible.
In more practical terms, greater certainty about future inflation allows people to make spending and investment plans with more confidence. This helps to encourage long-term investments that contribute to strong, sustainable economic growth and bring real improvements to our standard of living over time.
Of course, low inflation brings many other direct benefits. It facilitates smoother wage bargaining, encourages longer-term contracts, and helps to keep long-term interest rates lower and more stable. Keeping inflation low also protects the purchasing power of pensioners and other Canadians on fixed incomes.
At the heart of monetary policy is the inflation-control target that the Bank of Canada and the federal government established for Canada in 1991. Our target for inflation is based on the Consumer Price Index (CPI). The target is set at 2 per cent—the midpoint of a 1 to 3 per cent range. Since the adoption of inflation targeting, inflation has averaged close to 2 per cent. More importantly, expectations for future inflation have also come to be solidly anchored at 2 per cent—an indication of the credibility of the target.
The Bank exerts its influence over the inflation rate mainly through changes to its target for the overnight interest rate—the rate at which financial institutions borrow from each other to meet their daily cash needs. This rate is set and announced eight times a year on pre-determined dates and is, of course, the subject of widespread interest before and after the announcement dates. You know that on 19 October the Bank raised the target for the overnight rate to 2.5 per cent, an increase of one-quarter of a percentage point. I will talk about that in a few moments.
Inflation targeting requires a balanced approach. If inflation is moving towards the top of the target range, that is usually a sign that demand for goods and services is too strong and needs to be restrained through a rise in interest rates. If inflation is moving towards the bottom of the range, it is often a sign that demand is weak and needs some support through a reduction in interest rates. In this way, monetary policy can act as a stabilizer for the economy.
Changes in the overnight rate target are based on the Bank's assessment of where inflation is likely to be 18 to 24 months down the road, because that's how long it takes for the effects of interest rate actions to spread through the economy and have their full influence on inflation. As you might imagine, we carry out continuous, intensive monitoring of the economy as part of our monetary policy function. The staff in our regional offices contribute to this work. They conduct regular surveys of local businesses concerning their outlook for sales, investment, employment, and labour shortages, among other key variables.
Monetary policy based on an inflation target, and supported by a flexible exchange rate, has helped Canada weather a number of economic storms in recent years, including the Asian crisis of 1997-98, the bursting of the high-tech bubble, and the global economic slowdown in 2001-02.
There is little doubt that uncertainty and occasional volatility will continue to be part of the economic environment in which we all operate. But we want Canadians to know that they can depend on the Bank of Canada to conduct monetary policy in a way that contributes to a positive, stable environment that is conducive to solid, sustainable economic growth.
