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Understanding Interest Rates and Monetary Policy in Canada
Interest rates have been rising steadily since March 2022 as the Bank of Canada (BoC) works to reduce inflation to its 2% target. Early indicators suggest that this strategy is effective, with inflation decreasing from a peak of 8.1% in June 2022. To understand why rates are high and when they might decrease, it's useful to grasp how monetary policy operates and the BoC's history with interest rates.
The Role of the Overnight Rate
The Bank of Canada uses the overnight rate, also known as the policy interest rate, to influence inflation. This rate is the interest at which banks borrow and lend money to each other overnight.
Every day, banks adjust their balances through transactions, needing to settle any discrepancies by borrowing or lending in the overnight market. Banks can also borrow from the BoC at the bank rate or deposit funds at the deposit rate. The difference between these two rates is called the operating band. Currently, the target rate is 5%, with the deposit rate at 5% and the bank rate at 5.25%. Previously, the operating band was 0.5%, with the policy rate at the midpoint.
These rates indirectly affect various types of borrowing, including:
- The prime rate set by commercial banks for mortgages and lines of credit
- The interest earned on savings, GICs, and other deposits
Historically, the BoC has used different methods to set the bank rate, including fixed and floating rates. Since June 1994, the BoC has used the target for the overnight rate as its primary monetary policy tool.
Why the Bank of Canada Adjusts Rates
The BoC adjusts interest rates to manage inflation. Higher rates are used to cool down an overheating economy and curb inflation, while lower rates stimulate economic activity during a downturn.
Raising rates has several effects:
- Increases in borrowing costs for consumers and businesses
- Reduced consumer and business spending
- Higher savings rates, leading to slower economic growth
The effects of rate changes typically take 12 to 18 months to manifest in the economy.
In a February 2024 speech, Bank of Canada Governor Tiff Macklem noted the gradual and sometimes painful effectiveness of monetary policy, reflecting on the stability of inflation and economic activity in the years before the pandemic.
Understanding these dynamics helps in anticipating future rate changes and their potential impact on the economy.
