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The Bank of Canada’s Influence on Interest Rates

The Bank of Canada’s Influence on Interest Rates
Written by
  • Ashley Howard
| 10 May 2024
Reviewed, 10 May 2024
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    The Bank of Canada (BoC) carries out monetary policy by changing the target for the overnight rate (policy rate) 8 times each year. This overnight rate influences short-term interest rates, which lenders use to set their prime rates.

    Key Takeaways

    • The BoC uses the policy rate to stimulate or cool economic activity based on market indicators such as inflation.
    • The BoC policy rate directly affects all variable lending interest rates. 
    • Lenders’ prime rate is typically set at +2.20% from the policy rate.

    Overview of the Bank of Canada

    The Bank of Canada, established in 1935, plays a crucial role in the Canadian economy. According to the Bank of Canada Act, the BoC is the nation’s central bank tasked with regulating and sustaining Canada’s financial system and economy. Its primary responsibility is to “promote the economic and financial welfare of Canada.”

    The Bank of Canada manages the country’s monetary policy. This is mainly done by establishing the target for the overnight rate, commonly called the key policy rate or simply the policy rate. By adjusting this rate, the BoC can impact the monetary supply and effectively regulate the Canadian economy. 

    The Bank of Canada is also in charge of issuing Canadian currency, overseeing foreign currency reserves, and supervising financial systems, fund transfers, and retail payment systems through its various other departments.

    Understanding the Target Overnight Rate

    The Bank of Canada (BoC) utilizes the target overnight rate, also called the policy rate, as the primary tool for regulating inflation in Canada. This rate is the basis for determining various interest rates throughout the Canadian economy. Inflation is measured primarily through the Consumer Price Index (CPI), which has an inflation target of 2%. 

    The policy rate does not directly impact the general public but influences the overnight market. This market is responsible for settling payments and funds transfers among Canadian Financial Institutions at the close of each business day. On a daily basis, customers at different banks and credit unions engage in transactions such as bill payments, debits, and transfers.

    These transactions between them need to be settled, even international wire transfers. In cases where there is a deficit in their transfers, these institutions will borrow from each other at the overnight rate through the BoC. The central bank establishes a ‘target’ overnight rate as the benchmark for the interest financial institutions charge when lending overnight loans. 

    Changes in the Overnight Rate

    Over the past 12 years, the lowest policy rate was 0.25%. This was seen throughout over half of 2020 and the entirety of 2021. As inflation soared, the BoC eventually raised the key policy rate to where it remains today at 5.00%.

    Predicting the BoC Overnight Rate in 2024

    There is a split within the BoC Governing Council about maintaining the policy rate to control inflation. However, experts predict that the policy rate will not be increased further. The current rate has been enough to bring inflation under control as we come closer to reaching the 2% target. Experts predict we will only see a few small rate cuts in 2024.

    According to the median response, the latest Bank of Canada (BoC) Market Participant Survey predicts that initial rate reductions will begin in Q2 of 2024. This survey collects and shares the opinions of senior economists and strategists within the Canadian financial market.

    History of Overnight Rates From the Bank of Canada

    1935: The Bank of Canada Established

    Following the severe economic downturn of the Great Depression in North America, the Bank of Canada Act was proposed in late 1934. As a result of the economic crisis, the Bank of Canada was established the following year. In March 1935, the Bank of Canada was made accessible to public investors, and subsequently, in 1938, was taken over by the government and became a crown corporation.

    1935-1945: Great Depression and WWII

    The world was gripped by severe social and economic turmoil during the Great Depression in the early 1930s. Canada, in particular, faced a devastating impact from this crisis, with widespread unemployment, bankruptcies, and homelessness. In 1935, the Bank of Canada initially set its interest rate at 2.5%. By the end of World War II, the rate had decreased to 1.5%, as the economy had experienced significant growth during the war.

    1945-1955: Post War Era

    In October 1955, the Bank of Canada rate saw its first increase to 2.0% after a prolonged period of stability. The Canadian economy experienced significant growth following WWII, particularly in the primary and secondary sectors. The post-war era’s low interest rates allowed Canadians to increase their investments in infrastructure, housing, and consumer goods.

    1977-1991: Stagflation

    Following a period of sustained growth following the war, the BoC rate increased until the 1980s, reaching its highest point of 20.03% in August 1981. This remains a record high since the BoC was established. The rate varied between 15% and 7.5% in the late 1980s and early 1990s.

    1991-2008: Economic Recovery

    Beginning in the early 1990s, the Bank of Canada’s rate has consistently been on a downward trend. However, there have been some instances, such as in the late 1990s, when the rate experienced a sudden increase before eventually declining again. To address this, the Canadian government implemented a target inflation rate in 1991 and has since periodically revisited and adjusted this rate, which is currently 2%.

    2009-2017: The Financial Crisis

    The financial crisis during 2007-2009 was caused by a prolonged period of easily accessible credit and relaxed lending standards, leading to a housing bubble that eventually burst. This resulted in major financial institutions in North America being burdened with trillions of dollars of bad debt, specifically in the form of subprime mortgages. 

    In response to the collapse, the Bank of Canada promptly decreased the key policy rate to 0.5% in March 2009, marking the first time the rate dropped below 1%. Since then, the rate remained within approximately 0.75% of the 1% threshold.

    2018-2021: The Impact of COVID-19

    Before the worldwide pandemic, the Bank of Canada’s interest rate remained steady at approximately 1.75%. However, in March 2020, as the pandemic spread throughout North America, the rate was decreased by 150 basis points (1 basis point is equivalent to 0.01%) from 1.75% to 0.25%, in alignment with the actions taken by the Federal Reserve in the US.

    2022-2024: The Fight Against Inflation

    From March 2022, rates began to rise again to control increasing inflation. The first increase of 25 bps occurred in March 2022, followed by another 50 bps in April 2022, ultimately reaching a rate of 1.00%. The overnight rate experienced a 50bps increase in June 2022, bringing the rate to 1.50%. 

    In July of the same year, a significant increase of 100bps resulted in the targeted overnight rate being set at 2.50%. Inflation rose to 8.1% in June, up from 7.7% in May. This was the largest annual increase since January 1983. The rise in June was widespread but primarily driven by increased fuel prices.

    The Bank of Canada continued to increase the target for the overnight rate by 75 basis points to 3.25% in September 2022. Officials indicated that interest rates would need to be further raised due to the inflation forecast, as surveys showed that expectations for short-term inflation remained elevated. 

    It was also noted that the impact of COVID-19 outbreaks, ongoing supply disruptions, and the conflict in Ukraine continued to hinder growth and drive up prices. As 2022 came to a close, two additional rate increases of 50 bps (equivalent to 0.50%) took place in October and December, resulting in a year-end policy rate of 4.25%.

    The Bank of Canada increased its policy rate by 25 basis points (0.25%) in 3 of its rate announcements during 2023, ending the year at 5.00%. So far in 2024, the BoC has maintained the 5.00% policy rate as monetary policy works its way through the economy, slowly bringing inflation under control and closer to the 2% inflation target. 

    Frequently Asked Questions

    Why is the policy rate significant?

    The BoC uses the policy rate as the primary tool for controlling inflation. It stimulates or slows the economy to regulate inflation and keep it within the 2% target. 

    When inflation increases, the policy rate is increased to slow the economy and discourage borrowing and spending to bring inflation back to the target. When inflation decreases, the policy rate decreases to encourage borrowing and spending to bring inflation back up to the target. This rate also impacts variable-rate products banks and lenders offer, such as mortgages.

    How often does the policy rate change?

    The Bank of Canada changes the policy rate on 8 fixed dates each year to carry out monetary policy. This means the rate could change up to 8 times a year on these dates but could also remain unchanged based on economic conditions.

    How does the target for the overnight rate work?

    The overnight rate serves as a benchmark for the interest rates that financial institutions charge each other when borrowing and lending to balance transactions at the end of each business day. Financial institutions will also increase or decrease their interest rates for variable-rate products such as mortgages when the overnight rate changes.

    Final Thoughts 

    The target for the overnight rate is a significant financial tool for fiscal policy. It is the interest rate at which financial institutions borrow funds from the government’s central bank. The policy rate impacts various other rates, including savings rates and, most crucially, variable mortgage rates. 

    To explore your interest rate options for 2024, contact us today for advice and a mortgage solution tailored to your unique circumstances.