How does the Financial institution of Canada’s rate of interest work?

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Fuelling the likelihood of a rate hike is the consumer price index (CPI), which measures inflation. In January 2022, inflation rose 5.1% from a year earlier, marking the first time it has exceeded 5% since September 1991, according to Statistics Canada.

“I think [Bank of Canada governor] Tiff Macklem remains concerned about the pace of GDP growth and employment, and he’s balancing these concerns with inflation,” says Michael Parkin, a professor emeritus in economics at Western University. “That’s why he didn’t raise interest rates [in January]. I think it was a wrong decision, but it wasn’t unreasonable [to do so].”

All signs point to the Bank raising interest rates in the coming months. National Bank believes a rate increase from 0.25% to 0.50% during the Bank’s March 2 policy meeting is a “foregone conclusion.” The financial institution, one of many to predict a rate hike, expects the Bank to raise its interest rate up to 1.50% by the end of 2022. 

Changes in the Bank’s overnight rate will almost inevitably impact you in one way or another, whether you’re applying for a mortgage, repaying a student loan or living off retirement income. So we take a look at how the Bank’s policy rate works and what it means for you and your finances. 

What is the Bank of Canada interest rate? 

Before we define the Bank’s policy interest rate, also known as the overnight rate, it helps to understand inflation. Inflation is a persistent increase in the level of consumer prices or a persistent decline in the purchasing power of money. Gradual inflation over time helps keep the economy strong by making increases in wages and expenses predictable for businesses and consumers. But inflation that exceeds the norm makes it more difficult for people to afford everyday expenses.  

The Bank aims to keep inflation stable at 2%—or between the target range of 1% to 3% per year. That’s where the overnight rate comes into play: It is the Bank’s primary tool for controlling inflation. The overnight rate influences how the banks will set their own rates. It acts as a sort of barometer for the rate at which major banks borrow and lend among themselves. When the Bank raises the overnight rate, it becomes more expensive for banks to borrow money, and those costs get passed onto borrowers through higher interest rates.

What happens when the Bank of Canada raises or lowers interest rates?

If the economy is struggling to grow or experiencing a shock, as it did during the COVID-19 pandemic, the Bank can slash interest rates to help boost economic activity. When the overnight rate falls, people and businesses pay lower interest on new and existing loans and mortgages, and they earn less interest on savings. This generally leads them to spend more, which in turn helps strengthen the economy. 

Conversely, an economy that is growing too quickly can lead to high levels of inflation. In this scenario, the Bank might raise the overnight rate, forcing people and businesses to pay higher interest on loans and mortgages. This discourages them from borrowing, reduces overall spending and typically brings inflation under control. 

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