A previous article explained how central banks are structured and how they affect you.
Now, you’ll learn more about the measures that central banks use to support economies.
What is monetary policy?
Monetary policy refers to the measures that central banks use to influence economies, by either driving growth or suppressing it. Central banks primarily focus on controlling the amount of money that flows in and out of economies, both domestically and internationally. They do this by setting interest rates which, in turn, influences inflation.
- Interest rates affect how expensive it is to borrow money, as well as how much you earn on your investments and savings.
- Inflation refers to how fast the prices of goods (e.g., gas and groceries) and services increase over time, which relates to how valuable your money is compared to how much these items cost.
Central banks mainly focus on inflation and interest rates when making monetary policy decisions. But they also assess how fast their economies are growing and how many people have jobs. Plus, they look at what governments are doing to support their economies.
So why are interest rates and inflation the main focus?
Keeping interest rates and inflation at acceptable levels is important when there are financial or market downturns. This is also the case when growth is too robust, since too much growth can push inflation higher, causing the price of goods, such as groceries, to rise faster than your wages.
“As an average Canadian, if your wages don’t go up as prices go up, then your standard of living is eroding,” says Darcy Briggs, vice-president, portfolio manager at Franklin Bissett Investment Management in Toronto. “In the 1970s, when inflation was over 8% , there were strikes and all kinds of labour unrest.” At that time, people wanted higher pay since their wages only went up 3% and the prices of goods went up 8%. So their dollars were shrinking — they couldn’t afford to buy as many products or pay as many bills.
In contrast, inflation typically falls when the overall demand for goods and services falls. But if inflation drops too much, then there’s a risk of deflation (a continual decrease in the general prices of goods). Low prices can be good for consumers, says Briggs, but they’re bad for the economy over the long term.
For instance, if prices fall over a long period, “then you might start to say, ‘Well why would I buy [a car or house] today if prices will be lower tomorrow?’ Over the long term, that can stall consumption and economic activity and, as a result, overall demand slows too much,” he explains. You also get a buildup of supply, which can negatively affect the earnings of companies and performance of certain sectors (including housing and energy). Slow demand can also impact employment.
Currently, the benchmark for inflation is set at 2%. This is fast enough to keep the economy producing, but slow enough that your wage growth can keep up, says Briggs.
Great. But how is monetary policy used when economies are weak vs. strong?
There are two types of monetary policy: expansionary and contractionary. Briggs says expansionary policy involves central banks trying to add money to the economy to help it grow, while contractionary policy involves a central bank trying to take money out of the economy to impede growth.
The most obvious way to impact economic growth is through setting interest rates, he adds, which occurs eight times per year in Canada by the Bank of Canada (BoC) and, in the recent years, the same amount of times in the U.S. by the U.S. Federal Reserve (the Fed).
MoneySense reports that when the BoC wants to increase inflation or boost growth during downturns through expansionary policy, “It can drop its overnight rates, [which] allows banks, lenders and credit unions to lower interest rates on products such as variable mortgage rates, car loans, and other consumer loans to stimulate more borrowing. This increases demand and, subsequently, boosts inflation.”
In contrast, MoneySense adds, the BoC can cool the market through contractionary policy “by increasing overnight rates. Major banks will follow suit, by raising interest rates for consumers. The theory is Canadians will spend less if it costs more to borrow and, ultimately, this reduces inflation,” by reducing demand for goods.
However, adds Briggs, “We haven’t seen a contractionary policy [in Canada] since 2004 to 2006.” Since then, our country’s prolonged recovery from the recession has slowed growth. And, to stimulate you to buy and invest, the BoC has been lowering interest rates–the Bank has even stated that setting negative rates is a possibility if the economy were to deteriorate.
Do central banks use any other measures?
Central banks can also support economies through quantitative easing (QE), which involves a central bank buying government bonds or other securities from the public market in order to increase the money supply. Briggs says it’s a measure that central banks use when interest rates are already low and they don’t want to set them close to or below 0%. QE helps boost growth and encourage spending.
Angelo Melino, an economics professor at the University of Toronto, says, “To implement [QE], central banks look at their willingness to introduce liquidity, or add more money, to the economy.” And, when buying bonds and other securities, central banks must explain what they expect to happen to the target interest rate in the future. They also have to plan how they’ll sell these bonds and securities when they stop using QE.
Dropping interest rates below 0% is an unconventional alternative. Few central banks have introduced negative rates, but the Bank of Japan (BoJ) is one that has.
Briggs says the BoJ introduced negative interest rates because the country has been dealing with deflation and poor growth since the 1990s. “Negative rates are very experimental. The theory is if you go negative and charge [retail] banks for their deposits to the central bank, then they will instead lend that money out to put money back into the economy. However, the actual outcome of negative rates is unknown.”