The Bank of Canada has been trying to escape the U.S. Federal Reserve Bank’s shadow for some time now while acknowledging that, at the same time, it must factor U.S. monetary policy moves into its decision-making process. Unlike the Fed, the Bank has an inflation target—a 1 percent to 3 percent range with a specific focus at the 2 percent midpoint. Although the Bank monitors many economic indicators, as indeed all central banks do, the Bank converted its inflation barometer for operational purposes to a consumer price index measure that subtracts eight volatile components to better reflect core inflation. It also takes the foreign exchange rate for the Canadian dollar into its monetary policy decisions.

The Bank changed the way it announces its monetary policy decisions in late 2000. Since then, meetings and announcements have been scheduled for eight times a year along with an assessment of the Canadian economy. This effectively broke the link between Canadian and U.S. monetary policy. The Bank no longer responds directly to Fed moves, although the Bank can change policy between official announcements if it chooses.

The Bank carries out monetary policy by influencing short-term interest rates by setting the overnight target. This in turn affects monetary conditions — that is, the impact of short-term interest rates and the Canadian dollar’s exchange rate on the economy. The transmission of monetary policy occurs as changes in monetary conditions affect the demand for goods and services. Lower interest rates, for example, tend to increase spending and reduce savings, and a lower dollar can boost exports and hold back imports. Conversely, higher interest rates tend to curb domestic spending and a higher dollar tends to curb exports and encourage imports. Strong demand for Canadian goods and services puts upward pressure on prices if it exceeds the economy's capacity. Changes in monetary conditions affect inflation only indirectly and are usually felt over a period of 18 months to two years.

Monetary policy goals are to aid and abet solid economic growth along with rising living standards. To achieve these goals, inflation is kept low, stable, and predictable. The inflation control target is at the heart of Canadian monetary policy. The level of interest rates and the exchange rate determine the monetary environment in which the Canadian economy operates. Inflation targeting has been a cornerstone of monetary policy since 1991, when the government and the Bank of Canada agreed to target inflation for a five-year period. The Bank and government have updated the agreement every five years since with the most recent renewal occurring in December 2006.

Specifically, the Bank aims to keep the rate of inflation, as measured by the year-over-year percent increase in the CPI, inside the target range of 1 percent to 3 percent. The CPI was chosen as inflation’s measure because it was well known to the population. The Bank aims to keep inflation near the 2 percent midpoint. Although the inflation target is stated in terms of the total CPI, the Bank uses a measure of core inflation as an operational guide. The measure, in their opinion, provides a better measure of the underlying trend of inflation and tends to be a better predictor of future changes in the total CPI. This core measure excludes eight volatile items—fruit, vegetables, gasoline, fuel oil, natural gas, mortgage interest, intercity transportation and tobacco products as well as the impact of changes in indirect taxes on the remaining components.

After remaining at 4.25 percent between May 2006 and July 2007, Bank of Canada’s policy interest rate was increased to 4.5 percent at their July meeting, where it remained until their December 2007 meeting. At that meeting the Bank lowered its key interest rate to 4.25 percent because of the tumult in the financial markets as well as lowered inflation expectations. In the not so distant past, Canada needed to have its interest rates higher than the U.S. in order to prevent massive investment outflows south of the border.