Changes in interest rates independent of those in the United States are made possible by our flexible exchange rate regime. Let me explain how monetary policy focused on an inflation target plays a stabilizing role when there are demand surprises. Suppose that the economy is operating at its production potential, and inflation is at the 2 per cent target midpoint.
A downward shift in demand—coming from, say, a tightening in fiscal policy—would create excess supply in the economy, putting downward pressure on inflation. To bring inflation back to 2 per cent over an 18- to 24-month horizon, the Bank of Canada would lower its target for the overnight interest rate.