Monetary Policy 101

Monetary Policy 101 Bank of Canada and Interest Rates

The Bank of Canada influences interest rates for consumers and businesses. The “overnight rate”, set by the Bank of Canada is the foundation rate that all other interest rates are based upon. It is the rate that banks use when they lend money to one another to settle debit payments, electronic transfers, and other money flows between banks. The rates for mortgages and home equity loans, credit cards, business loans and other financing are derived from the “overnight rate”.

Raising the “overnight rate” eventually makes all borrowing more expensive and will in-turn slow the economy and inflation. The opposite is also true; lowering rates decreases the cost of borrowing, encourages economic expansion and the rate of inflation. In addition to its mandate to support maximum sustainable employment the Bank of Canada aims to maintain inflation at an annualized rate of 2% and within a range of 1 to 3 percent.

What You Need to Know

In addition to lending and borrowing with one another, banks can also utilize the Bank of Canada. Funds deposited to the bank earn the “deposit rate and funds borrows pay the “bank rate”. Currently, the “overnight rate” anchors at 0.25% operating band between the “deposit rate” and the “bank rate”. Adjustments, up or down, to the “overnight rate” directly change the other interbank rates. Below is an example with the “overnight rate’ set at 2.25%.

This range is not accessed by the public to borrow or deposit but when financial institutions operate within this range it also affects interest rates they provide to their customers. When the Bank of Canada changes the “overnight rate,” by extension it also changes the rates charged for loans, mortgages, lines of credit and for deposits, GICs and other savings.

The Bank of Canada adjusts its “overnight rate,” primarily, in response to inflation. Inflation below the Bank’s 2% target indicates that the economy could be growing too slowly, and its other mandate, maximizing employment, might be in jeopardy. In this situation, the Bank would lower rates to drive more spending that would boost the economy, including employment. This situation occurred most recently during the early phases of the pandemic when the “overnight rate” was lowered to 0.25% in March 2020.

Once the pandemic began to subside, supply chain issues arose, international commerce resumed, and recovery began. Demand rose faster than supply and pushed prices quickly higher. Consumer inflation rose quickly to about 8%, and the Bank of Canada responded by raising its “overnight rate” from 0.25% to 5% from March 2022 to July 2023.

The effects of a higher overnight rate have been dramatic over this period. All have risen. Borrowers, like those with variable-rate mortgages, have been dramatically affected. The monthly payments on a $500,000 mortgage with a 25-year amortization rose from $2,366 at 3% interest to $3,610 at 7.35%; the variable rate offered by TD in early April 2024.

Higher costs for all types of loans (mortgages, home equity loans, credit cards, etc.) have trimmed demand, and lowered the rate of inflation to 2.8% in February 2023 according to StatsCan. A period of predictable and lower inflation will allow central banks to lower their rates, and in-turn lower, borrowing costs for individuals and businesses.

The Bottom Line

Monitoring the underlying indicators that influence interest rates can inform the size and timing of purchases. Economic theory and the Bank of Canada’s objectives suggest that stable prices facilitate rate reductions. All indications point to rate reductions starting in the second half of 2024, and continuing over the following two years if the trajectory of lower inflation continues. However, the Bank of Canada is concerned that lower interest rates could overheat the housing market with rapidly rising prices, which could spur higher inflation, again.

The uncertainty associated with the timing and size of Bank actions encourages conservative behaviour for borrowers. Based on the Bank’s statements, it appears that rates have peaked, which provides depositors with opportunities that will vanish when rates fall.

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