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March 18, 2021 – Monetary policy stimulus alone won’t cause a financial crisis in Canada, says a new report from the C.D. Howe Institute.

On the heels of the Bank of Canada reiterating they will keep interest rates low, authors Jeremy Kronick and Steve Ambler explore the effect monetary policy has on financial stability and consider whether Canadians should be worried about the impact of low interest rates.

In “The Impact of Monetary Policy on Financial Stability” the authors explain that while necessary during the COVID-19 crisis, there is concern that low interest rates and the massive expansion of the Bank of Canada’s balance sheet will lead to significant growth in private debt and a reckoning down the line.

To study the impact of monetary policy on financial stability, Ambler and Kronick use a novel financial vulnerabilities barometer, which includes household debt servicing, and estimates the impact monetary policy has had on the barometer from 1990-2019. Building on previous work, the authors show that the inclusion of household debt servicing considerably improves the barometer’s ability to track financial vulnerability, and that the debt-service ratio is the most reliable predictor of trouble ahead.

Ambler and Kronick look at two scenarios – contractionary monetary policy and expansionary monetary policy and their impact on this financial vulnerabilities barometer. The authors find that contractionary monetary policy causes the vulnerabilities barometer to fall, thereby reducing financial vulnerabilities, while expansionary monetary policy shocks, triggered by a lower than expected bank rate, have little to no significant impact. In other words, low interest rates doesn’t lead to concern over financial instability.

The authors conclude that monetary policy – in particular expansionary monetary policy – does not work at cross-purposes to regulation intended to ensure financial stability. This means that if the Office of the Superintendent of Financial Institutions (OSFI) enacts a new policy meant to stabilize the housing market, for example, lower interest rates will not counteract the positive contribution of OSFI’s policy. 

“Our results suggest that the Bank of Canada can conduct its monetary policy with confidence that there will be few or no negative side effects on financial stability,” says Ambler. “Although it won’t be monetary policy that causes financial instability, there are other concerns on the horizon, including unanchored fiscal policy.”

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For more information contact: Jeremy Kronick, Associate Director, Research, C.D. Howe Institute; Steve Ambler, David Dodge Chair in Monetary Policy and Professor of Economics (retired) at the Université du Québec à Montréal; or Nancy Schlömer, Communications Officer, C.D. Howe Institute, email: nschlomer@cdhowe.org.

The C.D. Howe Institute is an independent not-for-profit research institute whose mission is to raise living standards by fostering economically sound public policies. Widely considered to be Canada's most influential think tank, the Institute is a trusted source of essential policy intelligence, distinguished by research that is nonpartisan, evidence-based and subject to definitive expert review.