A very very simple explanation of monetary policy

Scale & weights | Aylmer, Quebec | Canadian Museum of History

 

This post is for my dad, who says he doesn't understand my writing but remains a loyal reader nonetheless.

I am going to try and explain one of the most important things that central banks do: monetary policy. We often see news clips in which bespectacled central bankers discuss their "inflation targets," or tell us that they are ratcheting interest rates up or down, or that they are engaging in "quantitative easing". The catch-all term that we use to describe what they are doing is monetary policy. But what does this mean? What is monetary policy?

Central banking is confusing, so here's what I propose. Let's find something simple, something we all intuitively understand. And then I'll show why monetary policy is like that simple thing. Hopefully that demystifies what is going on. I'm going to use a Canadian example, but it applies just as well to any nation.

K50, K75, and K106

People take their national system of weights & measures for granted. But we simply couldn't function as a society without a standard way of measuring things: kilograms, metres, seconds, or degrees Celsius.

A nation's system of weights & measures doesn't just manage itself. Take the kilogram. The Canadian Federal government had to push and prod for years to get the kg into popular usage. Canadians had historically relied on the imperial measurement system with its strange mix of ounces, drams and grains. In 1970, Pierre Trudeau passed the Weights and Measures Act, giving birth to the Metric Commission and its mandate to get Canada officially onto the metric system. Fifty years later we Canadians all reckon in terms of kilograms, grams, and a raft of other metric measures. (Ok, not entirely, I admit. I cook in Fahrenheit, not Celsius, and weigh myself in pounds, not kg. But I definitely don't drive in miles.)

The Canadian government's job didn't stop once the kilogram was widely accepted. It has continued to manage the kilogram ever since. The main thrust of this ongoing effort is to ensure that 1 kilogram is 1 kilogram all across Canada. No agency is more involved in this harmonization effort than the National Research Council of Canada, or NRC, the Federal government's research and development lab.

National Research Council building in Ottawa

The NRC's headquarters in Ottawa houses three individual physical kilogram weights. Known as K50, K75, and K106, these specimens represent Canada's official kilograms. Because Canadian manufacturers require incredible precision, they can periodically visit the NRC and calibrate their weights against K50, K75, or K106 to ensure accuracy. If the manufacturer's weights diverge by even a few micrograms from the NRC's official weights, they will have to be replaced with more accurate ones.

And so the definition of the kilogram diffuses across Canada, first from the National Research Council, then to industry, and finally to Canadians who consume carefully weighed products.  

The National Research Council's K50, K74, and K106 are in turn copies of the most important kilogram weight in the world, the International Prototype Kilogram. Manufactured in 1889, the IPK is stored at in the International Bureau of Weights and Measures (BIPM) in France. Scientists at the National Research Council used to periodically hop on a plane with K74 and fly to France to cross-check it against the IPK.

In 2018, the world stopped using physical artifacts to define the kilogram. The problem with using actual objects like the IPK and K50 is that over time they suffer from slight degradation. K50, for instance, began to display fluctuations of a few micrograms due to "tiny cracks in the surface which adsorbed and released water from the air." And so our standard for weight suffered. 

We now rely on a much superior non-physical standard for the kilogram, one that is defined in terms of Planck's constant. But even though the definition of the kilogram has changed, the National Research Council is still key in ensuring that the kilograms Canadians use are good kilograms.

The beginning of the long dash...

The National Research Council also maintains Canada's official time. Cesium atomic clocks are the world's most accurate method for recording the passage of time, of which the NRC's time standards office in Ottawa has several. The NRC broadcasts official time on the web, via short wave radio band, and by telephone. Faithful CBC radio listeners will all be familiar with the NRC's habitual: "The beginning of the long dash indicates exactly one o'clock..." For $7,500 per year, industrial customers can even get authenticated access to NRC time servers.

An NRC control room containing systems used to disseminate official time to the public, including the telephone talking clock, the CBC daily time broadcasts, and computer time clocks.

Precise timing is particularly important to the Canadian financial industry. Take the Investment Industry Regulatory Organization of Canada, or IIROC, which regulates the Toronto Stock Exchange and all the firms that deal on it. (IIROC is sort of like Canada's version of the SEC). To ensure that all market participants are on the same rhythm, IIROC sets its internal clock off of the NRC's clocks. All firms that trade in Canadian securities must in turn synchronize their clocks to IIROC's clock. And thus the NRC and its atomic clocks impose order on the chaos of the stock market. 

kg, s, and $

Now let's bring this back to monetary policy. 

The main suggestion in this article is that readers put the National Research Council and the Bank of Canada in the same bucket. Both institutions are responsible for upholding Canada's system of weights & measures. 

But whereas the NRC is in charge of managing physical measures, the Bank of Canada is responsible for managing the nation's key unit of economic measure, the $. So when you see news about the Bank of Canada and the dollar, and you start to get confused, consider reframing the news as if it was the National Research Council making policy changes to the way it manages the kilogram. Hopefully that will make the news more relatable.

The dollar is the universal sign we Canadians use to express economic value. It shows up in grocery aisles, at online stores, in our bank statements, and is used in our heads to calculate bills.

But like the kg, the $ must be managed. As I wrote earlier, the NRC originally defined the kilogram in terms of a physical artifact before switching to a non-physical construct. Likewise, a long time ago the Canadian dollar was set at 23.22 grains of gold. But these days the Bank of Canada (much like the NRC) measures the dollar in terms of a theoretical construct, a basket of consumer goods.

What does it mean to measure the dollar in terms of a basket of consumer goods? 

Each month government statisticians canvas store aisles and websites for price data which they use to calculate the cost of purchasing a basket of consumer goods. This data compilation is known as the consumer price index, or CPI. It includes items like groceries, rent, gas, etc. 

In its definition of the dollar, the Bank of Canada promises citizens that the $ unit will be capable of buying the same amount of consumer baskets from one month to the next. (It's a little more complicated than that, but that's for another post).

So then what are interest rates for?

Sometimes the Bank of Canada will make the news because it is increasing or lowering interest rates. What is happening here? Recall that the National Research Council had a number of tools for diffusing official time across Canada, one of which is broadcasting across channels such as the CBC. The Bank of Canada also has tools for diffusing its definition of the dollar across Canada. Interest rates happen to be its favorite tool.

If the dollar falls in value such that it is no longer powerful enough to purchase the appropriate quantity of consumer baskets, the Bank of Canada will increase rates. In theory, this pushes the dollar's purchasing power back up to target. And if the dollar is too powerful and purchases more baskets than the Bank of Canada's target, the Bank will decrease rates. This should nudge the dollar's purchasing power back down.

Updating the definition of $

So when experts discuss standards bodies like the National Research Council or the Bank of Canada, they are likely having two sorts of discussions. Half of their conversations will be about the definitions that these institutions uphold (i.e. should we define the kilogram using K50 or Planck's constant? Should we define the dollar in terms of grains of gold or consumer goods?). And the other half will be about strategies and tools for diffusing the standard across Canada (i.e. should we provide the public with more channels for accessing official time? Should we increase interest rates or keep them unchanged?)

The Bank of Canada is currently in the thick of the first sort of discussion. Every five years the Bank of Canada and the government come to an agreement about how the Bank will define the dollar for the ensuing five years. The next agreement is scheduled to be inked in 2021. 

Some people involved in this discussion want to adopt new definitions for the dollar. Recall that the Bank of Canada already uses consumer basket to define the dollar. One group wants to redefine the dollar in terms of nominal gross domestic product. Others want to add a reference to employment. 

Much like discussions about whether to redefine the kilogram in terms of Planck's law, this is a complicated debate, one that non-experts cannot easily access. But whatever the decision, you can be sure it will have implications for all Canadians. After all, the $ is a measure that each on of us uses on a daily basis.