The Bank of Canada has raised its trendsetting policy rate to try and cool inflation. Here's a breakdown of what the rate does, and what an increase — likely the first of multiple rate hikes this year — mean for households, businesses and governments.
What is the key policy rate and what does it do?
The key policy rate, also known as the target for the overnight rate, is the interest rate the Bank of Canada wants commercial banks to charge when lending each other money overnight so they settle balances at the end of each day. Knowing how much it will cost to lend money between institutions, or deposit money with the Bank of Canada, helps set commercial interest rates charged on things like loans and mortgages.
How does a rise in rates cool inflation?
The key rate is also the Bank of Canada's biggest tool to manage inflation. When the economy is in a downturn and inflation rates are low, the bank lowers the rate to promote spending. Raising rates has the opposite effect by cooling spending when inflation rises above the Bank of Canada's comfort zone of between one and three per cent. Changes in the rate can have some immediate impacts, but the effect on inflation rates usually takes between six and 18 months to appear.
What does a rate increase mean for households and businesses?
Rates.ca and Ratehub.ca note that homeowners with variable rate mortgages are likely to see an increase in mortgage payments since the prime interest rate charged by banks generally moves with the central bank's key rate. For those with a fixed-rate mortgage, the impact of higher costs won't arrive until renewals in the coming years.
Royce Mendes, head of macro strategy with Desjardins, said higher central bank rates tend to dampen demand for homes and durable goods like cars, appliances and home electronics, all of which consumers have been spending heavily on during the pandemic.
Mendes says a lone rate hike won’t do all that much to change spending habits immediately. It will likely take more hikes and a drop in virus transmission to cool spending on goods as part of a shift to oft-restricted in-person services.
Does this have any effect on federal finances?
In its fall economic update, the federal government said a one percentage point increase in interest rates decreases the budgetary balance by $4.9 billion in the first year, $5.8 billion in the second year, and $6.4 billion in the fifth year as borrowing costs would increase.
Rebekah Young, Scotiabank's director of fiscal and provincial economics, says a general rule-of-thumb is that an increase of 0.25 per cent in the Bank of Canada's overnight rate typically dampens economic growth by about 0.1 percentage points. Lower growth, she says, would quickly overtake higher interest as the key driver of any deterioration in the government's balance sheet.
This report by The Canadian Press was first published March 2, 2022
