Reversal of Fortunes: Rising Interest Rates and Losses at the Bank of Canada

Abstract

The Bank of Canada is responding to high inflation by increasing its policy interest rate. With the Bank having recently expanded its balance sheet by buying government bonds and increasing its liabilities to financial institutions, higher policy rates have immediate implications for the Bank of Canada’s own finances.

The bonds were largely purchased from financial institutions, and the proceeds from the sales were overwhelmingly added to the institutions’ deposits, or settlement balances, at the Bank of Canada. This dramatically increased the size of interest-earning deposits at the Bank.

Financial institutions’ deposits at the Bank of Canada earn interest at the deposit rate, which means that rising interest rates increase the Bank’s interest expenses. These expenses now exceed Bank of Canada revenues, and a large financial loss will result – a first in Canadian history. The Bank has always earned a profit since its founding in 1935.

We estimate cumulative losses of between $3.6 billion and $8.8 billion over the next two to three years, depending on the projection scenario. While this does not undermine the Bank’s ability to conduct monetary policy, it does create novel reputational and communications challenges for the Bank at a time of elevated public attention on its activities. It also creates a direct financial cost for the federal government.

Though details of how such losses will be treated are under development, we propose they be (i) subtracted from Bank reserves, or (ii) accumulated within a deferred account; either way, future profits should be used to eventually cover today’s losses. Whichever course is chosen, future amendments to the Bank of Canada Act are almost surely in store.

Keywords: Monetary Policy, Central Banking, Financial Stability, Inflation and Inflation Control, Interest Rates, Policy Guidance, Fiscal and Tax Policy, Government Debt and Deficits

JEL Classification: E58, E62, E43