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Why Does The Bank of Canada Raise Interest Rates? How Far will The Rate Hikes Go?


Under Mortgage

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June 28th, 2022

Anyone who owns a house or has been thinking about buying has heard a lot lately about rising interest rates. It’s a very hot topic of discussion, with economists and news outlets constantly watching the Bank of Canada for hints about what may come next.

While most people understand that rates are going up and have a general idea of what it means to them, many may still lack a full understanding of just how these rates play into the broader Canadian economy.

The average Canadian has little impact on the overall course of the Canadian economy, but this doesn’t mean they shouldn’t understand how it all works. Despite what may seem like a dull topic, the decisions of our Central Bank affect us all on a near-daily basis. And, though you can’t change what they choose to do, understanding the purpose and impacts of their decisions can help you to make the best decisions for your financial health in response.

This article will cover the basics that all homeowners or homebuyers should know about how interest rates work, why they are on the rise, and what it means for them.

What ‘rates’ exactly are going up?

You will commonly hear talk about ‘interest rates’ with little explanation of which interest rates we are talking about. There are hundreds of different interest rates: for mortgages, credit cards, investments, and more.

More specifically, the ‘interest rate’ in question is usually the Bank of Canada’s (BoC) policy interest rate, also known as the target overnight or benchmark interest rate. This rate, in particular, gets the honour of being known simply as the ‘interest rate” because it plays a key role in influencing many other interest rates in the Canadian financial system, though not all.

Essentially, this rate represents the cost for banks to borrow money from the central bank and between one another, which they do on a daily basis to rebalance their holdings. This cost, in turn, leads to another key interest rate known as the bank’s prime rate. Technically each bank has its own prime rate, although they tend to keep them on par with one another.

The prime rate represents a basic cost of borrowing money for consumers and is determined by adding a premium to the overnight rate. This premium covers all the other costs of lending money that a bank has to cover so that it can still make a profit.

The bank will use the prime rate to determine many interest rates for their lending, most notably for variable-rate mortgages. As you can see, the bank rate set by the BoC can have a big impact downstream on everyday Canadians.

Other rates are going up, too, such as fixed mortgage rates, though these are not connected directly to the Bank of Canada policy rate. You may also hear about the inflation rate, which is a whole other beast entirely.

Why does the Bank of Canada raise rates?

So far, we have established that the Bank of Canada increases their interest rates, which has a downstream effect on many other interest rates. But why exactly does the Bank of Canada raise the rates in the first place?

You can find the simple answer in the Bank of Canada’s primary mandate: to keep inflation low. Their goal is to keep inflation at a rate of around 1% to 3% per year, as measured by the Consumer Price Index. The Bank of Canada, beyond anything else, is concerned with managing inflation at a healthy level to keep the Canadian economy on course. They have a few different monetary policy tools they can use to achieve this mandate, but the most powerful is their ability to set interest rates.

Because the Bank of Canada is the sole issuer of Canadian banknotes, they essentially control the flow of money into the economy. The simplified idea behind inflation is that prices increase in response to a larger supply of currency in circulation to purchase the same goods. By controlling exactly how much money enters circulation, the bank can help to control inflation.

By increasing the cost of borrowing money from the bank, they can reduce the overall demand for money. People tend to spend less and save more when interest rates are high, which reduces spending and helps to slow the rise of inflation in response.

The causes of inflation are complex, and many are international factors beyond the influence of the Bank of Canada. However, there are some domestic causes as well. Factors such as government benefits during the COVID-19 pandemic, rapid growth in house prices, and supply chain issues leading to low supply and increased commodity prices have worked together to grow inflation. Some may also point to corporate price gouging as a cause of inflation. While there has likely been some of this, it is not the only cause of inflation, nor the largest.

Luckily for us, we are in good company when it comes to inflation. Though we can not control international factors, central banks worldwide are also working to slow inflation in their respective countries, which should help the overall global economy.

How far will the rate hikes go?

No one can say for certain exactly how far the Bank of Canada will go in pushing interest rates up. Current estimates predict rates to continue increasing at least until the end of the year. With the Bank’s stated intent of lowering the inflation rate, they will essentially continue to raise rates until inflation is brought under control.

As of now, and despite an over 1% increase since the start of the year, the inflation rate is still on its way up. So yes, you can expect the Central Bank to raise rates again, likely multiple times this year.

Current predictions put the Bank of Canada policy rate somewhere between 2% and 3% by the end of the year. This would be in line with the interest rates seen in the 2000s, though notably higher than rates in the 2010s.

In fact, despite recent hikes, Canadians are still enjoying historically low-interest rates. Rates have been on an overall downwards trend since at least the 1980s when the interest rate in Canada peaked above 20%.

The last time inflation was as bad as it is now was in 1983 when interest rates were around 10%. Though we can’t directly compare the economic conditions in the 80s to our present day, it is clear that higher rates are not unprecedented, and in fact, our current low rates are more uncommon in the grand scheme of things.

What does a rate increase mean to me?

Though the Bank of Canada deals with high-level monetary policy, these changes’ effects are felt throughout the Canadian economy.

The biggest and most obvious effect on Canadians is rising mortgage rates. This is especially true for those who bought their homes in the last couple of years and opted for the lower-at-the-time variable-rate mortgages.

Increases in interest rates are reflected in variable mortgage rates almost immediately, and these borrowers will now start to see their monthly expenses increase significantly. This is made even worse because many new buyers got into the market while prices were particularly elevated, meaning they are paying higher interest on an even higher value loan.

If you have a variable mortgage rate, it may be worth looking at your options for refinancing or locking in a fixed rate if you feel that increased payments will be too much to bear. By knowing what is coming, you can do your best to protect yourself from default.

Though the Bank of Canada’s interest rate doesn’t directly affect fixed mortgage rates, other aspects of their monetary policy, such as quantitative tightening, will also put upward pressure on the bond yields that help determine these rates. As a result, homeowners may see an increase when it comes time to renew.

For those with a fixed-rate mortgage, increased rates may come sooner or later depending on your mortgage term, and those who bought prior to 2020 may not see much of an increase if they renew soon. Luckily, this may mean you have time to prepare for increased mortgage costs.

As mortgage rates go up, homebuyers will not be able to afford the same high prices, so home values may drop somewhat. While a housing correction is far from a total crash, it could still mean sellers may end up with less money from selling their homes than they may have expected.

Interest rate hikes also affect many other forms of borrowing. This may include home equity loans and some credit cards, among others. In general, this will discourage a lot of borrowing in the near future as debts become harder to service.

Businesses also will have to react to an increased cost of borrowing. Not only will their costs go up, but the number of customers they have may decrease. This will encourage businesses to keep prices low. In the long term, this works to reduce the inflation rate, which will hopefully be seen as a positive even if it comes after a few years of pain.

However, if the economy shifts too fast, spending may be so limited that businesses are forced to lay off their workers to cut costs. This period of mass layoffs and economic contraction is better known as a recession, and there is a real risk of such a scenario happening in Canada in the near future.

Ultimately, the bank of Canada is in a tough spot in the fight against inflation. What follows will likely be a period of increased costs for Canadian homeowners, reduced spending power, potential job losses and more.

Luckily the economy works in a cycle, and despite the pain that may come from rising interest rates now, it will benefit the Canadian economy in the long run. Unfortunately, we are already in a bad position, and while it would have been best if we weren’t here in the first place, there is a way out, even if it takes some time to reach. The best thing Canadians can do now is prepare to protect themselves from financial turbulence, reevaluate their risk tolerance in investments, and work to reduce their spending and borrowing.

Why are Interest Rates Going Up in 2022? by Corben Grant | Canadian Real Estate Wealth

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