Why the Bank of Canada is Increasing Interest Rates

On June 7th, the Bank of Canada (BoC) increased its benchmark interest rate by 0.25%, meaning most lenders’ prime rates will increase to 6.95%. Bank of Canada’s policy interest rate is now 4.75%, the highest level in 22 years. The recent decision by the BoC to increase interest rates has stirred discussions about its implications for different aspects of the economy.

Generally, this rate increase typically impacts variable rate mortgage holders and influences the amount of money people pay when borrowing from banks for various loans.

When the benchmark interest rate goes up, banks will increase their own prime rates. The prime rate is the interest rate banks charge their most trustworthy customers. It can be confusing as some will refer to the BoC rate as prime rate as well or overnight rate. The BoC increases or decreases rates to stimulate or slow down the economy. Traditional banks, in turn, try to maintain a profit based on a spread between the cost of their source of cash and the rate at which they lend it out. 

On their website, the BoC says, the policy interest rate was increased to reflect “[their] view that monetary policy was not sufficiently restrictive to bring supply and demand back into balance and return inflation sustainably to the 2% target.”

In other words, the Governing Council believes the previous rate was not effective enough in managing the balance between the supply and demand in the economy and keeping inflation at a stable level.

According to the Government of Canada, when interest rates rise, borrowing becomes more expensive, affecting various forms of credit, including mortgages, personal loans, and credit cards. The Government of Canada explains that “interest is the amount you pay to your lender to use the money”. Higher interest rates mean that individuals pay more in interest charges when they borrow money. As a result, their monthly payments may increase, leaving them with less disposable income. Additionally, increased borrowing costs can discourage investment and consumer spending, which can have an impact on the overall economy.

Interest rate fluctuations can create a divergence between countries, affecting the relative value of their currencies. Divergence is a policy term often referring to interest rate fluctuations between countries which can affect the value of their currency. When the BoC raises interest rates while other central banks maintain or lower theirs, it can make Canadian investments more attractive, potentially strengthening the Canadian dollar. Nick Lioudis says in an Investopedia article, “Higher interest rates in a country can increase the value of that country's currency relative to nations offering lower interest rates.” However, a strong currency can impact exports and make Canadian goods relatively more expensive, which may affect international trade and competitiveness.

Interest rates can also influence the housing market, more specifically, home ownership. Initially, rising interest rates can temporarily decline housing prices as affordability and demand decrease. However, over the long term, the impact on housing prices depends on various factors, such as supply and demand. A 2022 TD Bank article says, “Even if the price of housing may be going down, house hunters might not be able to qualify for mortgage amounts quite as large as they might have been able to in the past.” We need more supply in the housing market to create affordability. Challenges related to housing supply, such as inventory and construction constraints, can alleviate the downward impact on prices.

The Bank of Canada’s decision to increase interest rates is driven by the need to maintain price stability and manage inflation. However, this can have wide-ranging effects on various sectors of the economy. Disposable income, small businesses, and the overall economy can experience the impact of increased borrowing costs. Moreover, the divergence between Canada and other central banks in terms of interest rates can influence currency values and trade dynamics. In the housing market, interest rate fluctuations can temporarily impact home prices, but long-term trends are often shaped by supply and demand factors.