The target for the overnight rate-the main tool used by the Bank of Canada to conduct monetary policy. The Bank carries out monetary policy by influencing short-term interest rates. It does this by raising and lowering the target for the overnight rate. The overnight rate is the interest rate at which major financial institutions borrow and lend one day funds among themselves; the Bank sets a target level for that rate. This target for the overnight rate is often referred to as the Bank’s key interest rate or key policy rate.
Changes in the target for the overnight rate influence other interest rates, such as those for consumer loans and mortgages. They can also affect the exchange of the Canadian dollar. In November 2000, the Bank introduced a system of eight fixed dates each year on which it announces whether or not it will change the key policy rate. The Target for the Overnight Rate is the main tool used by the Bank of Canada to conduct monetary policy for this reason, it is also known as the policy interest rate.
It tells major financial institutions the average interest rate that the Bank wants to see in the market where they lend each other money overnight. When the Bank changes the Target for the Overnight Rate, this change affects other interest rates in the economy. Canada’s major financial institutions routinely borrow and lend money overnight among themselves, in order to cover their transactions at the end of the day. Through the Large Value Transfer System (LVTS), these institutions conduct large transactions with each other electronically.
At the end of the day, they need to settle with each other. One bank may have funds left over, while another bank may need money. The trading in funds that allows all institutions to cover their transactions at the end of the day takes place in the overnight market. The interest rate charged on those loans is called the overnight rate. The transmission mechanism of monetary policy The transmission mechanism is the complex chain of cause and effect that runs from the Bank of Canada’s actions to changes in asset prices, aggregate demand, the output gap and, eventually, inflation.
Among economists, there is some debate about the nature of the transmission mechanism. Engert and Selody (1998), for example, emphasize the important distinction between the passive-money and active-money views of the transmission mechanism and argue that the possibility of making policy errors can be reduced by paying attention to both views. Even among those who agree on the broad nature of the mechanism, there is recognition of considerable uncertainty regarding the timing and quantitative importance of specific linkages.
A collection of speeches and research papers published by the Bank of Canada (1996) provides a mainstream view of the transmission mechanism. The transmission mechanism is best understood by tracing through the effects of a hypothetical policy decision. For example, consider a situation akin to that in the autumn of 2004, when the Bank had good reason to expect that the solid economic recovery occurring both in Canada and in the global economy would create pressures for Canadian inflation to rise over the coming months. In this case, the Bank’s policy response was to raise its target for the overnight interest rate.