The Bank of Canada Act should be amended to secure the central bank’s independence as part of the government’s five-year review of the institution, according to a report published by the

C.D. Howe Institute on Tuesday. Every five years, the Bank of Canada and the federal government enter a review of the central bank’s policy framework, with the next one scheduled for 2026.

The Bank of Canada has so far indicated that the upcoming review will address how to find better ways to measure underlying inflation and focusing more on how monetary policy impacts

housing affordability . Bank of Canada governor Tiff Macklem has said the two-per-cent inflation target will not be changed.

Last month, Bank of Canada deputy governor Rhys Mendes also said the central bank was mulling whether to stop referring to core inflation as its “preferred” way to track price changes.

The C.D. Howe report, titled “Don’t Take It for Granted: Strengthening the Bank of Canada’s Independence,” points to the need to ensure the Bank of Canada’s independence at a time when the autonomy of central banks is being questioned, particularly in the United States.

“Storm clouds are on the horizon, especially given the political pressure being applied on the Fed south of the border,” said co-author Steve Ambler, economics professor at Université du Québec à Montréal and the C.D. Howe Institute’s

David Dodge , chair in monetary policy, in a statement. “Action must be taken here in Canada. A good place to start is with targeted amendments to the Bank of Canada Act.”

The first recommendation by the authors is to re-examine the provision in the Bank of Canada Act that allows the federal government to issue directives to Canada’s central bank.

The change would make sure the directives were only used sparingly and that they would be required to be made public through Parliament, with the finance minister presenting it as a motion in the House of Commons.

“Such an amendment would allow the directive to be discussed in the House of Commons and to be subjected to the scrutiny of the opposition parties,” the report said. “It would also allow markets to react in advance of the issuing of the directive, giving room for markets to — in other words — discipline the government, thus raising the bar for issuing the directive in the first place.”

The second recommendation is related to the growing risk associated with the Bank of Canada’s negative equity position, which the authors noted at the time of writing the report sits around $9 billion.

The bank can typically fund its operations through the interest it earns on the bonds it holds, but the COVID-19 pandemic has challenged the central bank’s finances, with the bank embarking on a quantitative easing (QE) program between 2020 to 2021.

“However, as the bank started tightening monetary policy in 2022 in response to inflation, the interest paid on short-term settlement balances, which had increased significantly as a result of QE, started to grow,” the report said.

“In early 2023, the interest it paid on settlement balances began exceeding the interest it earned on the bonds on its balance sheet, leading to operational losses for the bank.”

While a central bank can operate independently with a negative equity position, if it becomes significant and sustained, it will ultimately affect its ability to finance operations.

“In Canada’s case, being dependent on direct financing through the federal government could subject the Bank of Canada to political pressure to pursue other goals and challenge its operational independence in achieving price stability,” the report said.

As a temporary measure, the 2023 federal budget added new section to the Bank of Canada Act allowing surpluses the bank earns during the financial year to be applied to its retained earnings — as opposed to transferred to the government.

The second recommendation is to provide a more permanent mechanism for the central bank to deal with its losses, as opposed to the temporary measures introduced two years ago.

“We recommend a specific change to section 27 of the Act to clarify that this retention is indeed allowed and is at 100 per cent when the bank is in a negative equity position,” the report said.

Authors of the report also highlight the “mission creep” happening with the central bank’s mandate, where it’s charged with achieving different policy goals such as a green transition, reducing inequality and achieving maximum employment, which may be better suited to for government policy.

“Once the Bank of Canada is more or less formally charged with achieving such goals, there will be political pressure to achieve them,” the report said. “The bank does not have the proper tools to achieve these goals, putting its credibility at risk.”

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