13.3.2 Monetary Policy Impact

Learn about the impact of monetary policy on the economy, securities market, and the effects of inflation on corporate profits and price-earnings multiples.

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.

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## What is the primary role of the Bank of Canada? - [ ] To maximize corporate profits - [x] To promote Canada’s economic and financial welfare - [ ] To provide loans to individuals - [ ] To keep inflation high > **Explanation:** The primary role of the Bank of Canada is to promote Canada’s economic and financial welfare, mainly through monetary policy aimed at keeping inflation low, stable, and predictable. ## How does the Bank of Canada control inflationary pressures during periods of economic expansion? - [ ] By increasing government spending - [ ] By lowering interest rates - [ ] By decreasing the money supply - [x] By raising short-term interest rates > **Explanation:** During periods of economic expansion, the Bank of Canada may raise short-term interest rates to restrain the growth rate of money and credit, thereby controlling inflationary pressures. ## What action might the Bank of Canada take if the economy appears to be slowing down? - [x] Reduce short-term interest rates - [ ] Increase taxes - [ ] Raise short-term interest rates - [ ] Reduce government spending > **Explanation:** If the economy appears to be slowing down, the Bank of Canada may reduce short-term interest rates to increase the money supply and the availability of credit. ## What effect does a tilting of the yield curve indicate? - [x] A signal that investors approve of the slowing economic growth - [ ] A sign that inflation is out of control - [ ] An increase in short-term rates and long-term yields - [ ] A rise in long-term bond prices > **Explanation:** When short-term yields rise and long-term yields fall (a tilting of the yield curve), it signals that investors approve of the degree of economic slowing. ## What typically happens to long-term bond yields when short-term interest rates rise? - [ ] They increase significantly - [ ] They become highly volatile - [x] They tend to fall or rise at a slower pace - [ ] They remain unchanged > **Explanation:** As short-term interest rates rise, the rate at which bond yields increase slows down. Eventually, long-term bond yields may begin to fall as economic growth slows. ## How does inflation typically affect corporate profits and equity market prices? - [x] Higher inflation leads to lower corporate profits and lower equity market prices - [ ] Higher inflation leads to higher corporate profits and higher equity market prices - [ ] Inflation has no effect on corporate profits and equity market prices - [ ] Higher inflation increases both corporate profits and equity market prices > **Explanation:** Inflation leads to higher costs for manufacturers, which they attempt to pass on to consumers. However, this can't continue indefinitely, leading to a squeeze on corporate profits and lower equity market prices. ## What is the relationship between inflation and a corporation’s price-earnings multiples? - [ ] There is no relationship - [ ] Inflation has no impact on price-earnings multiples - [ ] As inflation rises, price-earnings multiples rise - [x] As inflation rises, price-earnings multiples fall > **Explanation:** There is an inverse relationship between the rate of inflation and a corporation’s price-earnings multiples. If inflation rises, investors are likely to pay a lower price for the corporation's earnings. ## What impact does higher real bond yields over time have on the equity markets? - [x] Increases competition between bonds and equities, undermining equity markets - [ ] Decreases competition between bonds and equities, raising equity market prices - [ ] Has no impact on the equity markets - [ ] Leads to a decline in bond market prices > **Explanation:** Higher real bond yields over time increase the degree of competition between bonds and equities, which can slowly undermine equity markets. ## What would be the Bank of Canada's likely action if inflation began to rise during an economic expansion? - [ ] Reduce short-term interest rates - [x] Raise short-term interest rates - [ ] Increase government spending - [ ] Decrease the money supply > **Explanation:** If inflation begins to rise during an economic expansion, the Bank of Canada is likely to raise short-term interest rates to slow economic growth and contain inflationary pressures. ## What happens to the prices of long-term bonds when investors expect slower economic growth? - [ ] They increase significantly - [ ] They become highly volatile - [ ] They remain stable - [x] They stabilize and yields decrease > **Explanation:** When investors expect slower economic growth, they purchase long-term bonds under the assumption that this will alleviate the need for higher interest rates. This increased demand for long-term bonds stabilizes their prices and lowers their yields.

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Tuesday, July 23, 2024