The Bank of Canada

The Bank of Canada (BOC) is a central economic and financial institution in Canadian government and politics. It oversees such important things as the national borrowing rates (interest rates), as well as the value of the Canadian dollar relative to other national currencies. This article introduces the Bank of Canada as an economic and political institution; in particular, it discusses the Bank’s roles and powers, its structure and modes of operation, as well as some of the issues and debates surrounding the Bank.

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Understanding the Bank of Canada

How the Bank of Canada Operates

The policies implemented by the Bank of Canada have a major impact on the Canadian economy. To fully understand the Bank of Canada, it is necessary to examine how it operates and its relationship with the federal Finance Department.

What is the Role of the Bank of Canada?

According to the preamble in the Bank of Canada Act, the Bank’s mandate is to:

• Regulate credit and currency
• Control and protect the external value of the national monetary unit
• Use monetary action to mitigate fluctuations in the general level of production, trade prices, and employment.

The Bank administers the nation’s currency, protects its value, and acts as the government’s and chartered banks’ official banker. The Bank of Canada’s most important function is to set monetary policies that will promote a healthy economy. This is accomplished primarily through taking steps to raise and lower interest rates.

How Does the Bank of Canada influence interest rates?

The key mechanism by which the BOC influences interest rates (or the cost of borrowing money) is through the setting of short-term rates. The BOC tells banks the average interest rate it wants to see on loans over a specified period of time. Since 1996, the BOC has used the overnight rate target, or the rate at which money is loaned to institutions overnight, to set monetary policy. A change in the overnight rate usually leads to a change in the prime interest rate.

The Bank of Canada’s Internal and External Structures

Internal Structures

The Bank of Canada is headed by:

• The Governor of the Bank of Canada, who serves as its Chief Executive Officer. The Governor is appointed for a seven-year period and can be reappointed.
• A Governing Council consisting of the Governor, the Senior Deputy Governor, and four deputy governors.
• A Board of Directors consisting of the Governor, the Senior Deputy Governor, and 12 “outside” directors appointed from across Canada. The 12 directors are appointed for a three-year period and can be reappointed. Their terms overlap. The Governor is the Chairman of the Board.

The balance of power flows from top to bottom. Ultimate authority resides with the Governor. The directors are expected to provide a perspective on economic conditions in their region. The Governing Council can take these perspectives into consideration when creating monetary policy, but it is not obligated to do so.

The Board of Directors is responsible for financial and administrative organization within the Bank, but the Governing Council maintains ultimate authority over these areas. The Board has no say in the formulation of monetary policy.

External Structures

The Bank’s mandate to “regulate and protect the national currency” means it plays a role in external organizations outside the main bank structure:

• Canadian Payments Association: Created in 1980, the Canadian Payments Association is Canada’s system for handling the transfers of funds between banks. The Bank of Canada does not own the Canadian Payments Association, but an officer of the Bank is Chairperson of the CPA’s Board of Directors.
• Business Development Bank of Canada: Formerly known as the Industrial Development Bank, the Business Development Bank (BDC) was created to stimulate investment in smaller manufacturing industries. Originally a subsidiary of the BOC, it now exists more independently; the Governor of the BOC is no longer the President. Over time, the BDC’s mandate changed to allow it to provide many services to small- and medium-sized businesses.
• Canadian Deposit Insurance Corporation: The CDIC is a federal Crown Corporation that was created in 1967 to provide deposit insurance to investors. The Governor of the Bank of Canada sits on the CDIC’s Board of Directors.

The Bank of Canada’s Relationship with the Federal Department of Finance

The Bank of Canada’s relationship with the government consists of both formal and informal mechanisms:

Formal

• The outside Board of Directors appoints the Bank Governor and the Senior Deputy Governor, with the government’s approval.
• The Finance Minister appoints a new director or reappoints a director when his/her term of office expires.
• The Deputy Finance Minister sits on the Governing Council and the Board of Directors, but does not vote.
• The Bank of Canada submits an annual report to the Department of Finance. The Governor must be available for questioning on the report by the House of Commons Standing Committee on Finance.

Informal

The Bank of Canada Act instructs the Governor to “consult regularly on monetary policy and on its relation to general monetary policy.” In practice this means that the Governor of the Bank meets weekly with the Finance Minister.

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History of the Bank of Canada

Why did Canada need a central bank?

To understand the Bank of Canada, it helps to understand the conditions that led to the creation of a central banking system. Here is a brief history of banking in Canada before and after the creation of the Bank of Canada.

Early Years of Banking in Canada

In 1817, the Bank of Montreal opened its doors, becoming Canada’s first bank. By the time of Confederation in 1867 there were 28 banks operating in Canada. The 1867 Constitution Act gave the new Dominion government control over banking and currency. Further, the establishment of the Canadian Bankers Association in 1891 gave banks a formal structure to communicate with the Dominion (national) government. The Bank Act of 1900 made membership in the Canadian Bankers Association compulsory.

During the 1800s, a combination of factors made it unnecessary to establish a central bank in Canada. Prior to Confederation, fewer banks were established in Canada than the United States, as the close relationship between business elites and government officials in Upper and Lower Canada made it more difficult for outsiders to obtain a bank charter. In addition, Canada’s smaller population and the prevalence of seasonally based industries such as agriculture and fishing made it more difficult for independent banks to operate. Instead, banks turned to branch banking to meet the financial needs of rural populations.

Branch banking expanded following Confederation, as banks obtained federal charters and established branches across Canada. During this period, several smaller independent banks, such as Newfoundland’s Union Bank, closed or were absorbed by the larger banks.

The development of fewer, larger banks, such as the Bank of Montreal, meant that the federal government did not have to establish a central bank to handle its financial business. Furthermore, the banks developed their own system for clearing cheques, removing the need for a central bank to do so.

The Need for a Central Bank

Although several proposals for a central banking system were put forth in the early 1900s, the federal government showed little interest. Prime Minister R.B. Bennett was the first Prime Minister to see the advantages of a central banking system. In 1931, he gave a speech announcing that Canada needed to have direct control over its monetary policy. He believed Canada should be able to independently settle its international accounts without having to go to Wall Street.

Meanwhile, the effects of the Depression of the early 1930s led people to criticize the way banks were run. Moreover, actions taken by the banks during this period helped produce a harmful deflation, in which a reduction in spending led to a fall in prices, which led to further spending reductions. These factors helped increase the momentum for a central bank in Canada.

In 1933, the government appointed a Royal Commission headed by Britain’s Lord Macmillan to examine the pros and cons of establishing a central banking system. In September 1933, after holding public hearings across the country, the Royal Commission released a report recommending the creation of a central bank, along with a draft constitution of its main features.

The Legislative Debates

A large portion of the legislative debates focused on the issue of private versus public ownership. At the heart of the issue was the nature of the BOC’s relationship with the federal government. Legislators were concerned that the BOC remain free from political interference, while at the same time remaining responsive to the financial and economic priorities set out by the federal Finance Department. The issue of BOC independence is still a hot topic today.

In February 1934, the federal government introduced legislation for the creation of a central bank. The bill closely followed the draft recommendations contained in the Macmillan Report; however, it gave greater emphasis to the central bank’s role in domestic economic policy than existed in the Macmillan Report. The Bank of Canada Act received Royal Assent in July 1934. In March 1935, the Bank of Canada opened under private ownership, headed by a Governor appointed for a period of seven years. The Bank Act was amended in 1938 to make it a publicly owned institution.

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The Bank of Canada’s Role in Managing the Economy

A look at the Bank ’s monetary policy throughout the decades

The Bank of Canada’s objectives and goals have undergone major changes since it was created in 1935. Here is an outline of pivotal shifts in the Bank of Canada’s monetary policy since its inception.

The War Years

Within days of declaring war on Germany, Canada introduced foreign exchange controls to protect the flow of foreign currency out of the country. In September 1939, a Government Order in Council established the Foreign Exchange Control Board. The Governor of the Bank of Canada was Chairman of the Board of Directors. The Bank of Canada helped finance the war effort by overseeing the sale of victory bonds and extending cash advances to the government.

The Post-War Years

In the years following World War II, the BOC’s focus switched from aiding the war effort to stimulating employment. In 1944, a subsidiary of the Bank of Canada, the Industrial Development Bank (IDB), was created to stimulate investment in small- to medium-sized manufacturing industries. The Governor of the Bank of Canada was also the President of the Industrial Development Bank.

Throughout this period, the Bank Of Canada’s monetary policy was designed to keep interest rates down. Although employment rates rose, critics argued the BOC was not doing enough to combat inflation.

The 1950s to 1960s

In the 1950s, inflationary pressures forced the Bank Of Canada to take a more active role in setting monetary policy. Initially, the BOC imposed controls on certain types of bank financing. This failed to stop pressure on the Canadian dollar, caused by factors such as high amounts of American investment capital and rising world commodity prices. In October 1950, the BOC decided to float the Canadian dollar. In doing so, Canada abandoned an agreement by all International Monetary Fund (IMF) countries to peg the value of their currencies to the American dollar. Floating the dollar made it easier for the Bank to impact the domestic economy through its monetary policy. The BOC expected this to be a temporary measure.

As inflation rates continued rising, the BOC adopted a policy of monetary restraint. In 1954, the BOC took steps to raise interest rates and reduce the supply of cash reserves to the chartered banks. This policy continued until the early 1960s, when the BOC found itself at odds with the expansionist policies of the Diefenbaker government.

1960s

In the early 1960s, the Bank of Canada continued with a policy of monetary restraint to keep inflation rates low. Critics blamed the Bank’s monetary policy for reduced economic activity and a rising unemployment rate. In 1962, the Bank of Canada and the government returned to the Bretton Woods system, pegging the Canadian dollar at US $0.925. Throughout the remainder of the decade, the Bank’s monetary policy tried to achieve a trade-off between achieving price stability and maintaining a healthy economy. It permitted a certain level of inflation to keep employment levels steady. The fixed exchange rate limited the Bank of Canada’s ability to cope with the inflationary pressures that increased throughout the 1960s.

1970s

In the early 1970s, inflationary pressures caused by unforeseen international events — such as the oil shock of 1973, blamed on the OPEC oil cartel — forced the BOC to return to a more independent monetary policy. In 1971, the BOC decided once again to float the Canadian dollar, to deal with pressures on the dollar caused by an influx of foreign capital. In 1975, the Bank of Canada adopted a policy of monetary gradualism to cope with “stagflation” — a combination of rising inflation and high unemployment. The BOC gradually lowered the rate of money growth, setting it just high enough to meet the needs of the economy. In late 1975, the Anti Inflation Board introduced Wage and Price Controls.

1980s

In 1982, the Bank of Canada abandoned the policy of monetary gradualism. Until 1988, the Bank of Canada operated without a specific target for monetary policy. The lack of a clearly defined monetary policy heightened the effects of external factors, such as a shift in US interest rates, on the Canadian economy. In 1988, the Governor of the Bank of Canada announced that price stability would be the Bank of Canada’s new objective in formulating monetary policy.

1990s-Today

In 1991, the Bank Of Canada introduced inflation-reduction targets as a means of achieving price stability. The BOC hoped that setting specific targets would stabilize the economy, since the long-term goal of monetary policy would be clearer. Originally, the targets were set at two and four percent annually, with a midpoint of three percent. In 1995, revised targets were set at one and three percent, with a midpoint of two percent.

Today, price stability remains the BOC’s primary monetary policy. In 1996, the Bank Of Canada switched to the Overnight Target Rate as the key factor in determining interest rates. In 2001, the BOC changed its definition of how the Consumer Price Index (the main measure of inflation) was calculated, to minimize the impact of volatile price swings in goods such as gasoline.

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Profiles of Current and Past Bank of Canada Governors

Profiles of the current and past Governors of the Bank of Canada

Graham Towers

Graham Towers was Governor of the Bank of Canada from 1934 to 1954. In 1920, Towers left law studies at McGill University to become Superintendent of the Foreign Trade Department at the Royal Bank of Canada. He left RBC in 1934 to become the Bank of Canada’s first governor. During his tenure, Towers introduced wage and price controls during World War II to control inflation. In 1950, he reacted to inflationary pressures by deciding to float the Canadian dollar, effectively abandoning the Bretton Woods Agreement.

James Coyne

James Coyne served as Governor of the Bank of Canada from 1955 to 1961. Coyne attended Oxford University as a Rhodes Scholar, then in 1938 he joined the Bank of Canada’s research department. He served in World War II, then rejoined the Bank in 1944. Coyne served as Deputy Governor from 1950 to 1954. During his time as Governor, Coyne pursued a monetary policy designed to lower inflation despite opposition from the Diefenbaker government (expressed through Diefenbaker’s Minister of Finance). The federal government tried, unsuccessfully, to fire him since only Parliament and not the executive can terminate the Bank of Canada’s Governor. Coyne subsequently resigned in 1961. The political fallout from this incident is considered to be one of the reasons why Diefenbaker’s Conservatives were defeated in the 1963 election.

Louis Rasminsky

Louis Rasminsky was the Bank of Canada’s Governor from 1961 to 1973. Rasminsky completed post-graduate work at the London School of Economics, and in 1930 joined the League of Nations as a specialist in monetary and banking matters. In 1940, he joined the Bank Of Canada’s Foreign Exchange Control Board. As Board Chairman, Rasminsky played a leading role in establishing a compromise between the US and British positions in discussions leading to the Bretton Woods Agreement. Rasminsky served as Deputy Governor of the BOC from 1955 to 1961.

After becoming BOC Governor, Raminsky insisted that the government should clarify the roles of both the Bank Of Canada and the Finance Department in setting monetary policy. He recommended returning to a pegged exchange rate for the Canadian dollar due to the fallout from the Coyne affair. A pegged exchange rate combined with increased government spending made it difficult for the Governor to implement monetary policies that would combat inflation effectively.

Gerald Bouey

Gerald Bouey served as Governor from 1973 to 1987. Bouey received an Honours BA in Economics from Queen’s University. He joined the Bank of Canada’s research department in 1948 and subsequently served as Deputy Governor from 1969 to 1972, then as Senior Deputy Governor from 1972 to 1973. While serving as BOC’s Governor, Bouey fought inflation by pursuing a policy of “monetary gradualism,” supported by wage and price controls. Interest rates rose dramatically under this policy, reaching 20 percent at one point. Inflation continued to rise, reaching almost 11 percent in 1987. The government continued to support the Bank of Canada despite rising unemployment and widespread criticism of the impact the BOC’s monetary policy was having on different sectors of the economy. Bouey resigned in 1987 after serving two terms as Governor.

John Crow

John Crow served as BOC Governor for one term, from 1987 to 1994. After graduating from Oxford University, Crow joined the International Monetary Fund (IMF); he covered Latin America where he saw firsthand the effects of runaway inflation. Crow joined the Bank of Canada’s research department in 1973. Between 1981 and 1987, he served as Deputy Governor and Senior Deputy Governor. During his tenure as Governor Crow fought inflation through a monetary policy of price stability; zero inflation was the ultimate goal of price stability. Crow also introduced inflation reduction targets. Under this policy, unemployment rates rose to over 10 percent by the 1993 federal election. Crow was highly criticized for producing a “Made in Canada” recession. Further, critics argued that Crow’s policies violated the Bank of Canada’s mandate. In the spring of 1994, the federal Liberal government refused to renew Crow’s appointment.

Gordon Thiessen

Gordon Thiessen spent one term as BOC Governor from 1994 to 2001. In 1963, Thiessen joined the Bank of Canada’s research department after receiving an MA from the University of Saskatchewan. In 1972, he received a Ph.D. in economics from the London School of Economics. Between 1973 and 1975, Thiessen was a visiting economist at the Reserve Bank of Australia. Between 1984 and 1994 he served as Deputy Governor and Senior Deputy Governor. As Governor Thiessen kept the inflation reduction targets of 1 to 3 percent previously announced by Crow, but abandoned the goal of zero inflation. He changed the phrase “inflation reduction target” to the less controversial “inflation control target.” Thiessen also introduced a number of initiatives to explain the Bank of Canada’s monetary policy to the general public.

David Dodge

As of June 2007, David Dodge is the Bank of Canada’s Governor, a position he assumed in 2001. Dodge earned his Ph.D. in economics from Princeton University and was an assistant professor in economics at Queen’s University. Highlights of his civil service career include positions with the Central Mortgage and Housing Corporation and the Department of Employment and Immigration. He became Canada’s Deputy Minister of Finance in 1992, a position he held until 1997. Dodge is the only BOC Governor who did not serve as a Deputy Governor with the Bank of Canada. In his first year in office, Dodge began cutting interest rates to stimulate the economy. He also faced a tough challenge after the 9/11 attacks rattled financial markets around the world and threatened to stunt economic growth. Dodge responded with a series of dramatic interest rate cuts, reducing the Bank’s key rate to 40-year lows. He also extended the inflation control target of 1-3 percent. Dodge’s first term as Governor ends in 2008; he has already informed the federal government of his plan to retire and not seek a second term.

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Assessing the Bank of Canada

Criticisms and proposals for reforming the Bank of Canada

Since its creation in 1935, the Bank Of Canada has struggled to keep free from undue political interference, while remaining receptive and responsive to government economic policy. The difficulty in reconciling these two, often opposing, goals has left the Bank open to criticism on several fronts.

Formal Structure

Structural criticisms centre primarily on the BOC’s mandate, and the structure of its governing bodies.

The Bank of Canada’s Mandate

The Bank of Canada’s mandate is to “regulate credit and currency in the best interests of the economic life of the nation, to control and protect the external value of the national monetary unit and to mitigate by its influence fluctuations in the general level of trade, prices, and employment, so far as may be possible within the scope of monetary action, and generally to promote the economic and financial welfare of Canada.”

This is a broad mandate, giving the BOC a greater role in domestic economic policy than was originally proposed by the Macmillan commission. Critics argue that it is both too ambitious and too ambiguous. One proposal suggests limiting the BOC’s mandate to a clearly defined monetary policy, such as achieving domestic price stability. Others have pointed out that this would be difficult, since the BOC’s monetary policy has changed over time. While price stability has always been one of the goals, originally it was not the main goal.

Another argument in favour of the original mandate is that it provides some protection against extreme shifts in monetary policy. It is the Bank Of Canada’s role in protecting against fluctuations in employment that led to accusations that Governor Crow overstepped the mandate when he set a goal of zero inflation.

The Structure of the Governing Bodies

The two main areas of criticism are the power of the Governor, and the lack of regional input into monetary policy:

Powers of the Governor

Critics oppose the concentration of power in one individual, the Governor, who serves as the BOC’s Chief Executive Officer and Chairman of the Board of Directors. In 1994, a governing council was created in an attempt to decentralize power. However, the Governor sits on the Council and maintains the final authority over policy. The Finance Minister meets weekly with the Governor, not the entire Governing Council.

Lack of Regional Representation

The Bank of Canada’s commitment to regional representation is limited to the 12 “outside” directors who sit on the Bank of Canada Board of Directors. The Governing Council maintains final authority over the Board of Directors. The outside directors are expected to provide a perspective on economic conditions in their region; however, the Governing Council is not obliged to act on these perspectives. The Bank of Canada has been criticized for implementing monetary policies that are more responsive to the needs of central Canada, particularly Ontario, over other regions of the country.

Relationship with the Government

Some critics have argued that the Bank Of Canada is too independent from the government, while others have argued that is not independent enough. The issue of BOC independence is closely intertwined with the contentious issue of the Governor’s power.

Past and Proposed Reforms to the Bank of Canada

Previous Reforms

In 1967, the Liberal Government revised the Bank of Canada Act to permit the Finance Minister to override BOC monetary policy in the case of a disagreement between the BOC Governor and the government. However, it would be difficult for the government to use this veto in practice because of the potential negative backlash from the international financial community. The ambiguity of the Bank Of Canada’s mandate makes it difficult to justify using the override. In 1994, the Governing Council was created in an attempt to spread decision-making power to more than one individual.

Proposed Reforms

Economists and political scientists have put forth several interesting proposals for reforming the Bank Of Canada’s structure. For example:

• Place responsibility for monetary policy in the hands of a regionally representative council, providing equal representation to all the regions;
• Allow provincial governments to nominate candidates for the council; and
• Give the federal government power to reject any candidate.

During the 1991 Constitutional talks, the federal government released a position paper that proposed the following changes to the Bank of Canada Act:

• Amend the mandate to clearly state that the Bank’s role is to achieve and maintain price stability;
• Require the federal government to consult with provincial governments before making appointments to the BOC’s Board of Directors;
• Keep BOC Directors informed on economic regions in their area through the creation of regional consultative panels; and
• Make the appointment of the Governor of the BOC subject to Senate ratification (from Shaping Canada’s Future Together: Proposals).

Changes to the Bank of Canada Act were dropped from subsequent constitutional talks.

Social Costs of the Bank of Canada Policies

The Bank Of Canada remained relatively free from public scrutiny until the early 1980s (and again in the early 1990s), when it began aggressively fighting inflation. Such BOC initatives involved increasing interest rates (the cost of borrowing) in order to slow the economy. Critics have argued, however, that such such BOC actions have a negative impact on large segments of society. Consumers and businesses have to pay more to borrow money, which can slow or even decline the economy. This, in turn, negatively affects the workers who may lose their jobs or face wage reductions as a result, as well as young persons attempting to enter the workforce for the first time.

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Links for More Information

List of links for more on this topic

re:politics (formerly, Maple Leaf Web) Links

• How is the Canadian Dollar Valued?: Exchange Rates, Currency Markets & Monetary Policy
• The Fall & Rise of the Canadian Dollar: Causes & Consequences of the Dollar’s Fluctuations

Other Links

• Bank of Canada
• Department of Finance Canada