Bank of Canada Interest Rate Hike: April 2022

As no surprise to anyone, the Bank of Canada (BoC) increased the overnight lending rate by 50 basis points (bps) on April 13, 2022. Economists predict 2 more 50 bps hikes this year, possibly with some 25 bps hikes as well.

So why is this happening? Let’s break it down a little bit.

The Overnight Rate

The overnight rate, also known as the key policy rate, is how much interest the BoC wants commercial banks to charge when lending each other money to settle daily balances (interest is generally charged at night for the balance left in an account). The banks need to know how much it will cost to lend money, or to deposit money with the central bank, so they can set interest rates on loans and mortgages.

When the economy slows, the overnight rate is generally lowered to stimulate economic activity by making it cheaper to borrow money to purchase goods and services, which helps the economy recover. We saw this at the start of the pandemic when the overnight rate was slashed. But for about a year now, the economy has been recovering, so the BoC raises interest rates to avoid excessive inflation.

The overnight rate impacts variable rate mortgages – as the BoC increases the overnight lending rate, mortgage holders with a variable rate mortgage will get notifications from their lender that the interest rate has gone up, and it will correspond with the increases determined by the BoC. 

Inflation

So what is inflation anyways? Inflation is the trend of a general increase in prices and a corresponding fall in the purchasing value of money. So as prices increase, people have to spend more money to buy the same amount of goods and services.

Inflation is very high right now because the demand for household goods is higher than supply levels. Here is why:

  1. Many people were stuck at home during the pandemic, so Canadians spent less on services and more on goods. This shift, combined with global production and supply-chain disruptions, caused a shortage of goods, which has caused prices to increase.
  2. Prices have increased for items beyond those directly impacted by supply-chain disruptions. For example, higher oil prices cause higher transportation costs, making all goods more expensive. And, food prices have been impacted by extreme weather that has damaged crops and made goods more expensive.
  3. Strong demand for single family homes in Canada are pushing up house prices.

The BoC is responsible for controlling inflation. The central bank’s inflation target rate is around 2%. Inflation in Canada is 5.7%, and the BoC expects it to average almost 6% in the first half of 2022 and not return to 2% until 2024.

And now, we have the war between Russia and Ukraine causing uncertainty in the economy as well. As noted on Twitter by Frances Donald, the chief economist for Manulife, “we are moving from COVID inflation to conflict inflation”. Already we are seeing gas prices spike, along with cost of groceries.

And if inflation stays higher for longer, which the BoC says will happen, then businesses will respond accordingly. They may be able to hold off price increases for the short term, but in the longer term they will respond by increasing prices.

Labour Market

If the cost for goods keeps increasing, then businesses will increase their prices to stay ahead of the rising cost of inputs. Workers, too,  are going to want higher wages to pay for the higher cost of living. In turn, that will mean businesses will charge more for the goods they sell – it could become a self-fulfilling cycle driving inflation higher.

We are also hearing in the news that some businesses are having a harder time attracting workers, and some companies are offering financial incentives to attract workers. The unemployment rate hit a historical low of 5.3% in March. All this will put upward pressure on the prices we all pay for goods.

Summary

We can expect the BoC to raise the overnight lending rate several times this year to slow inflation. This means variable rate mortgages, credit card interest rates, and other variable rate loans will all increase.

Sources:
https://www.cbc.ca/news/business/inflation-business-explainer-1.6362093
https://globalnews.ca/news/8757351/bank-of-canada-interest-rate-explainer/
https://www.bankofcanada.ca/2022/04/fad-press-release-2022-04-13/
https://www.bankofcanada.ca/2022/03/getting-inflation-back-to-target/#:~:text=The%20timing%20and%20pace%20of,press%20release%20about%20the%20decision

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