BoC raises key interest rate. Why is this important?

BoC raises key interest rate. Why is this important?

As economists at all 6 big banks predicted, the Bank of Canada (BoC) has raised the overnight rate to 1.75%. In this article, we explore why all these rates matter to every Canadian household, why the BoC has raised interest rates, and what to expect in the year ahead.

Why do interest rates matter?

To many, an interest rate announcement barely even gets noticed as one scrolls through their Facebook news-feed but this percentage is of upmost importance to almost every household. Why? It is used to calculate the cost of borrowing and return on savings throughout the economy which includes:

  • Mortgages

  • Credit cards

  • Car loans

  • Savings accounts

It’s also an indicator of how well the economy is performing. As rates rise, we can generally assume that the economy is performing well and inflation is near 2%.

Pay attention to interest rates to gain insight into what’s going on in the economy and what to expect in the future.

Terminology Debunked

Before we get into the details, it’s important to understand the keywords used when discussing interest rates, and have a basic understanding of how they work.

Interest Rate – Rate at which banks calculate your cost of borrowing money or your income from savings. It is typically shown as a percentage applied to the outstanding loan or the deposit balance.

Overnight Rate – The lowest interest rate in Canada, it is used to calculate the cost when one bank lends to another bank for one night (Hence overnight rate). The target for this rate is set by the Bank of Canada and it can be thought of as the base rate at which all the others are set against.

Bank Rate – The interest rate at which the Bank of Canada lends money to Canadian domestic banks.

Yield Curve – This shows the relationship between interest rates and how long money is being loaned for, at one level of risk. The riskless yield curve is the lowest interest rate available in Canada and is used to calculate interest on loans between domestic banks and the Bank of Canada, and it is also the rate charged to the Canadian Government on our national debt. Every other yield curve is set above the riskless curve, with the distance from the riskless rate determined by the riskiness of the loan.

As you can see the prime yield curve (what’s used to determine your mortgage rate) is above the riskless curve. This is because the risk involved in lending to those on the prime rate curve is higher, naturally a bank is more likely to pay back a loan than a single person who has bought a house.

Why has the Bank of Canada changed the overnight rate?

Yesterday, the BoC announced that the overnight rate would be raised to 1.75% and clearly said that more increases would come.

They did this because the economy has performed better than expected in the beginning of the year and NAFTA negotiations were recently settled. The housing market has stayed cool throughout the year in Vancouver, Calgary, and Toronto. The industry is still adjusting to tighter mortgage regulations and higher interest rates.

In summary, the economy is performing well and deflation isn’t a risk so the bank is raising rates to a more natural or “neutral level”.

Finally, inflation is trending slightly above the 2% target and will likely move higher.

What do we think will happen?

In the statement, the Bank made it clear that markets should expect interest rates to rise in coming months (The next is possible date is December 6th but most expect the next increase will wait until January 17th). This is largely because the bank will want to observe the effect of the latest increase on the economy before making the next move.

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