The Bank of Canada releases its decision on whether or not it will raise its key interest rate eight times a year. While this decision may seem distant and irrelevant to many, the reality is that a high interest rate affects virtually all Canadians, regardless of whether they have a mortgage or not. Overview.
On Wednesday we will find out whether the institution opts for the status quo or a new increase. As a reminder, the key interest rate has already been increased from 0.25% to 5% since March last year in the hope of combating inflation.
Layoffs in sight
Due to a high key interest rate, companies are at risk of having several of their projects put on hold.
“Every employee must be worried about this to some extent because it will have an impact on the desire of companies to invest money,” summarizes Pierre-Benoît Gauthier, vice president and investment strategy assistant at IG Gestion de Patrimoine and lecturer at the UQAC.
Without access to cheap money, companies can abandon projects that suddenly become unprofitable due to interest rates. Some may even resort to layoffs, as we have begun to see in the banking sector.
“It has the effect of slowing down the economy in general, but that is also the aim of the exercise,” Mr Gauthier stressed.
Without an increase, your iPhone would cost more
The Bank of Canada is not only fighting inflation with its interest rate hikes, but is also trying to protect the value of the Canadian dollar.
“The biggest factor affecting the value of the Canadian dollar is the difference between Canadian and American interest rates,” explained Pierre-Benoît Gauthier.
Unlike in Canada, the increase in the key interest rate in the USA had less impact. The vast majority of American homeowners have 30-year fixed-rate mortgages, so they are not yet affected by the increases, unlike Canadian homeowners who are more accustomed to 5-year or even variable-rate mortgages.
“The Bank of Canada is in a bad situation,” believes the specialist. She sees a slowdown in the Canadian economy and I am confident that the people at the Bank of Canada know that we need to stop this […]but if the Americans raise their tariffs and we don’t, the trip to Florida will be expensive and so will the iPhones, like all imports.
Safe return for pensioners
A high key interest rate does not only have negative aspects. It can also be a blessing for retirees and workers nearing retirement.
Until five years ago, financial planners had to advise their clients to take some risk by adding stocks to their portfolio. However, it’s not pleasant to be at the mercy of the stock market in retirement when you’d rather have a predictable income.
This is where the high key interest rate comes into play. “Today it is extremely easy to earn 4% interest. You can do this without risk. “Expectations of future returns for people who are cautious are much, much better than they were five years ago,” Mr. Gauthier noted, pointing to fixed-income securities that yield more because of high interest rates.
Thousands of dollars more for his house
Homeowners who hold a mortgage, particularly an adjustable-rate mortgage, are likely to be the ones who will most immediately feel the impact of a rate change.
For example, the holder of a $300,000 mortgage amortized over 25 years pays $1,270 per month at an interest rate of 2% – a rate that was possible at the height of the pandemic – compared to 2,101 US dollars at an interest rate of 7% as currently offered, a difference of almost US$10,000 within a year, according to calculations by the Financial Consumer Agency of Canada.
The slightest change in the base rate can therefore mean more or less hundreds of dollars for owners.
Quiet inflation
Finally, the main objective of the Bank of Canada with its interest rate increases remains to calm inflation, i.e. the increase in the prices of goods and services, in order to reduce it to a rate of 2% per year. Recall that inflation reached an annual peak of 8.1% in June 2022 before gradually declining since then. Last September it was 3.8% over a year.
As Canadians spend more on debt repayments due to the higher interest rate, they have to spend less on consumption, reducing price pressure.
This slowdown in inflation affects all Canadians, who stop taking the plunge every week when they spot price increases, especially during their trips to the grocery store.
But despite the Bank of Canada’s efforts, prices have not stopped rising. “Inflation has a tendency to remain stubborn. Nowadays we hear that inflation is falling. Yes, but it’s still a positive rate. In other words, prices are not falling, but rising more slowly,” noted Mr. Gauthier.
The key interest rate in brief
The key interest rate is the main monetary policy tool of a central bank such as the Bank of Canada and, in short, is the interest rate that banks must pay when they borrow money from the central bank.
In turn, banks are finding that they are offering loans at higher interest rates to individuals and companies.
Ultimately, the key interest rate has the function of controlling the development of the economy. At the start of the COVID-19 pandemic, the Bank of Canada and other central banks around the world cut their key interest rates to a minimum in the hope of stimulating the economy. On the contrary, during the recovery and the rise in inflation, the Bank of Canada raised its key interest rate to slow the economy.
The Bank of Canada has been responsible for setting the key interest rate since its founding in 1935. The definition of this interest rate and the mechanisms have changed over the decades, but since 2000 it has corresponded to the target overnight interest rate, or the average interest rate that large banks must use to lend each other money for a day.