13.3.2 Monetary Policy Impact

The Monetary Policy Impact

The primary role of the Bank of Canada (the Bank) is to promote Canada’s economic and financial welfare through monetary policy. The Bank achieves this by maintaining the value of the Canadian dollar by keeping inflation low, stable, and predictable. If these goals are threatened, it takes corrective action by changing the rate of monetary growth, thereby encouraging interest rates to reflect the change.

Role of Monetary Policy

During periods of economic expansion, the demand for credit grows (i.e., bank loans for individuals and businesses), and the prices for goods and services generally rise, creating inflationary pressures. If the Bank believes these pressures negatively impact the economy, they can restrain the growth rate of money and credit by raising short-term interest rates.

Conversely, if the economy appears to be slowing down, the Bank may increase the money supply and the availability of credit by reducing short-term interest rates.

Changes in monetary policy affect both interest rates and corporate profits, which are crucial factors affecting the prices of securities.

Impact on the Bond Market

When economic growth accelerates, bond yields tend to rise. If inflation begins during an expansion, the Bank raises short-term interest rates to slow economic growth and contain inflationary pressures. This action may lead to more moderate economic growth or a growth recession (temporary slowdown without becoming a full recession).

Diagram below illustrates the yield curve changing over time as a result of monetary policy:

    graph TD
	    A[Short-term interest rate hike] --> B[Initial rise in bond yields]
	    B --> C[Slower rise in long-term bond yields]
	    C --> D[Long-term rates stabilize below equities]
	    D --> E[Investors purchase long-term bonds]
	    E --> F[Falling long-term bond yields]
	    B -.-> |Inflationary pressure| D

Understanding the Tilting Yield Curve

• As short-term interest rates rise, long-term bond yields also increase but at a slower rate. This effect stabilizes over time.
• Continued short-term rate hikes slow down economic growth, stabilizing long-term bond prices.
• As economic growth prospects decline, long-term bond yields fall, suggesting investor satisfaction with the reduced pace of economic growth.
• Declining long-term rates reduce the competition between equities and bonds. Conversely, higher real bond yields over time increase competition between bonds and equities, undermining equity markets.

The Impact of Inflation

Inflation creates widespread uncertainty, undermining confidence in the future. These factors typically result in higher interest rates, lower corporate profits, and decreased price-earnings (P/E) multiples.

Effects on Manufacturing Costs

Inflation leads to higher inventory and labor costs for manufacturers. To maintain profitability, they generally attempt to pass these higher costs onto consumers in the form of higher prices. However, higher costs cannot be passed on indefinitely as consumer resistance eventually occurs. This pressure on corporate profits results in lower common share prices.

Price-Earnings Multiples and Inflation

Did you know? An inverse relationship exists between the rate of inflation and a corporation’s price-earnings multiples. When inflation rises, the value of future cash flows paid by the corporation decreases, leading investors to pay lower prices for the company’s earnings. This concept will be explored further in the next chapter when discussing price-to-earnings ratios.

Frequently Asked Questions (FAQs)

What is the primary objective of the Bank of Canada’s monetary policy?

The main objective is to promote Canada’s economic and financial welfare by maintaining a stable and predictable inflation rate.

How does the Bank of Canada respond to economic expansion?

During economic expansion, if inflationary pressures rise, the Bank raises short-term interest rates to restrain the growth rate of money and credit.

What happens to bond yields when the Bank raises short-term interest rates?

Initially, short-term interest rates rise, pushing bond yields up. Continued rate hikes tend to slow economic growth, at which point long-term bond yields may fall as investors purchase long-term bonds, satisfied with the slower economic growth rate.

How does inflation affect corporate profits and share prices?

Inflation increases inventory and labor costs, which manufacturers try to pass onto consumers. If they cannot fully do so, it reduces corporate profits, leading to lower common share prices.

Key Takeaways

• The Bank of Canada uses monetary policy to maintain economic stability by adjusting short-term interest rates to control inflation.
• Adjustments in interest rates impact bond markets, corporate profits, and ultimately the securities market.
• Rising inflation generally leads to higher interest rates, decreased corporate profits, and reduced P/E multiples for equities.

Glossary

• Monetary Policy: Actions by central banks to control the supply of money and influence interest rates.
• Inflation: The rate at which the general price level of goods and services rises, eroding purchasing power.
• Bond Yields: The amount of return on a bond investment, usually expressed as a percentage.
• Price-Earnings (P/E) Multiples: A ratio for valuing a company by comparing its current share price to its per-share earnings.
• Yield Curve: A graph that shows the relation between interest rates and the time to maturity of debt.
• Short-Term Rates: Interest rates on loan periods typically less than one year.