Monetary Policy 101: How the Bank of Canada Influences Interest Rates

The Bank of Canada plays a key role in setting interest rates, affecting both consumers and businesses. At the heart of these decisions lies the “overnight rate,” which serves as the foundation for most other interest rates in the economy. This rate is what banks use to lend money to each other, influencing mortgages, home equity loans, credit cards, and other financing options.

How Interest Rates Shape the Economy

When the Bank of Canada raises the overnight rate, borrowing costs rise, which can slow the economy and help control inflation. Conversely, lowering the rate makes borrowing cheaper, encouraging economic growth but increasing inflation risks. The Bank's primary goal is to maintain inflation at 2%, within a target range of 1% to 3%, while supporting maximum sustainable employment.

Key Mechanics Behind the Scenes

Banks interact not just with each other but also with the Bank of Canada. They earn the “deposit rate” on funds deposited with the Bank, and if they borrow, they pay the “bank rate.” Currently, the overnight rate is set at 0.25%, with adjustments directly affecting these interbank rates.

Though consumers can't borrow or deposit at these rates, the fluctuations significantly impact the interest rates offered to customers for mortgages, lines of credit, and savings products like GICs.

Responding to Inflation

The Bank of Canada adjusts its rates in response to inflation trends. When inflation falls below 2%, it signals economic weakness, prompting rate cuts to stimulate spending. For example, during the pandemic, the overnight rate was dropped to 0.25% to boost the economy.

However, as the pandemic’s effects waned, inflation surged to nearly 8% due to increased demand and supply chain disruptions. To control inflation, the Bank raised rates rapidly from 0.25% to 5% between March 2022 and July 2023. This had a notable impact on variable-rate mortgages, significantly increasing monthly payments for many homeowners.

Current Trends and the Future

As of 2023, higher borrowing costs have helped bring inflation down to 2.8%. This could lead to further rate reductions, lowering borrowing costs for consumers and businesses. However, there are concerns that cutting rates too quickly could reignite inflation, particularly in the housing market.

The Bank of Canada’s current position suggests rates have peaked, and we may see more rate reductions if inflation continues to decrease. This presents opportunities for borrowers, but the window may close as rates begin to normalize.

The Bottom Line

Understanding how the Bank of Canada’s decisions impact interest rates is key to making informed financial decisions. Keep an eye on economic indicators and stay updated with the Bank’s announcements to navigate future rate changes wisely.

Warm Regards,