On June 5, the Bank of Canada will make its latest interest rate announcement amid speculation that a cut may be possible. The potential cut comes after the Bank of Canada aggressively increased rates to battle inflation, which has largely been blamed for a rise in the cost of living.
But what role does inflation play in monetary policy and are the conditions right for a potential cut? Cristián Bravo is an associate professor in statistical and actuarial sciences and is the Canada Research Chair in Banking and Insurance Analytics at Western. He answered questions regarding inflation’s role in monetary policy.
Western News: Can Canadians expect an interest rate cut?
Cristián Bravo: Given the latest downward trend on inflation and economic growth (the production of goods and services in an economy), the idea of a rate cut is much more likely. We are seeing a generalized cooling down in the economy that has been persistent over a nine-month period, signalling that the efforts by the Bank of Canada have been successful. The fact that growth is now lower than expected, makes it more likely that the Bank of Canada will decide to ease on their position and start lowering the rate and seeing how the market reacts.
It will need to balance the potential risk of stimulating the economy too early, thus leading to a return of inflation, versus the chance that the slowing growth trend continues, and we enter a recession, as we seemed to have been on the edge of during the last two quarters of 2023.
Why would the Bank of Canada not cut rates?
CB: What may give the Bank of Canada pause are the numbers in the U.S.
Cristián Bravo
The economy there is still in excess demand and inflation has not eased. There has been significant volatility in the core consumer price index and consumption numbers, meaning that not even the Federal Reserve knows the right path to take. This affects us, as the Canadian rate and the U.S. rate cannot diverge too much, or the Canadian dollar will lose value significantly against the U.S. dollar, undoing some of the efforts of the Bank of Canada.
The Bank of Canada does have leeway to lower the rate but needs to be cautious because if the U.S. decides to keep rates high for a while, then we won’t be able to lower them at a higher speed. So, a moderate decrease of 25 basis points (or 0.25 per cent) is likely, although I wouldn’t be surprised if they decide to keep it at its current value and wait until the July meeting to see how the American economy evolves in relation to our own.
What role does inflation play in monetary policy?
CB: Inflation, growth and employment are the trinity of monetary policy. The Bank of Canada controls, through their policy rate, the price of lending money, and this directly controls how much money is available to go around. Too much money related to our capacity to produce goods and services leads to inflation. Too little, leads to a credit crunch and thus decreased growth.
Jobs are directly tied to this. An overheated economy, or an economy without as many workers as needed (as we had a few months ago), leads to inflationary processes, while an economy in depression leads to job losses as businesses need to adapt to the lower demand for their products and services. So, the Bank of Canada’s role is to set the incentives to either stimulate the economy, or to disincentive spending, and this is done by changing the cost of borrowing funds through monetary policy.
What are the benefits of raising or lowering lending rates?
CB: Lower rates mean more incentive to lend money, and thus to invest, hire, spend and produce more. If this is tied to a real need for those goods and services, then growth happens, salaries increase and employment grows. If there is more money than needed in the economy, and we are observing inflation as we were last year, then a higher rate has the opposite effect, disincentivizing spending and demand. The tricky part is reaching a rate that leads to sustainable levels of employment and spending so that we achieve growth and higher salaries while producing goods and services that are aligned with local and global demand.
