Demystifying the Central Bank's Interest Rate Policy
The overnight lending rate is at the core of the Bank of Canada's monetary policy. In this blog post, I will explain it’s role and what it means for everyday individuals.
Aiming for the Overnight Rate
The primary tool the Bank of Canada uses to curb inflation is the target for the overnight rate, often known as its policy interest rate. This rate serves as a foundation for setting many interest rates in the economy that are relevant to Canadians.
Understanding the Overnight Market
Every business day, financial institutions in Canada transfer funds amongst themselves to serve their clients. Whenever a debit card is used or an e-transfer is executed, money moves between financial institutions. By the end of each day, these transactions need to be settled. Some institutions may have dispensed more in payments than they received, while others may have taken in more than they dispersed.
To neutralize the transactions, financial institutions can borrow money from each other for one day in the overnight market. The Bank determines a target for the interest rate it prefers financial institutions to charge each other when they engage in these overnight loans.
The Role of Deposit Rate and Bank Rate
Financial institutions aren't required to borrow from each other to reconcile their transactions—they have the choice to engage with the Bank. They can deposit funds with the Bank at the deposit rate for one night or borrow money from the Bank at the bank rate for one night.
The difference between the deposit rate and the bank rate is known as the Bank's operating band, and its size can vary.
At the time of writing (May 2023), the range is one-quarter of a percentage point wide, with the deposit rate being the same as the target rate. This is known as a floor system, as the target is at the bottom of the operating band. In a floor system, if the Bank sets the policy interest rate at 2.25%, for instance:
the Bank's deposit rate was 2.25%
and the Bank's rate (the borrowing rate) is at 2.50%
Before 2020, the Bank generally held the range one-half of a percentage point wide, with its policy interest rate located in the middle. This is known as a corridor system. In a corridor system, the gap between the deposit rate and the lending rate is larger (a corridor):
the Bank's deposit rate was 2%
the Bank's bank rate (lending rate) was 2.50%
The Impact on Individuals
Though the public doesn't directly interact with this overnight market for lending or borrowing money, the Bank's policy interest rate and this market are indeed crucial. By promoting financial institutions to borrow and lend amongst themselves at rates near to the policy rate, the Bank influences interest rates on a variety of other borrowings in the economy, which include:
the prime rate of commercial banks (used for loans such as mortgages and lines of credit)
interest rates paid on deposits, guaranteed investment certificates, and other savings
Why the Target is Adjusted
If the economy is struggling to grow, it could push inflation significantly below 2%. As a response, the Bank might lower the policy rate so that other interest rates across the economy drop. This indicates:
Individuals and businesses pay lower interest on loans and mortgages and earn less interest on savings.
Lower rates often encourage people to spend more, thus enhancing the economy.
However, if the economy is growing excessively fast, it could cause inflation to rise. As a result, the Bank might increase the policy rate, which suggests:
Individuals and businesses pay higher interest on loans and mortgages.
This discourages them from borrowing, curtails their spending, and dampens inflation.
What this means for your Variable Rate Mortgage
In a strong economy, where the Bank of Canada is increasing the overnight lending rate, the Banks will be increasing their bank prime. As a result, variable-rate mortgage holders will see an increase in their interest costs and mortgage payments. Conversely, in a weak economy, the Bank of Canada is likely to decrease the overnight lending rate which will result in the Bank decreasing their Bank Prime. Decreases in Bank Prime mean that variable rate mortgage holders will see a decrease in their interest costs and monthly payments.
What this means for your Fixed Rate Mortgage
Fixed-rate mortgages do not change on the back of changes to the Overnight Lending Rate. Fixed rates stay the same for the entire mortgage term. If you are nearing the end of your fixed-rate mortgage term, it is important to know what it happening in the interest-rate market. Although fixed rate mortgage are not directly affected by changes to the overnight lending rate, changes to the overnight lending rate do create volatility in the forward fixed interest rate markets. As such, your mortgage renewal offers could be changing as rates change.
Connecting with a Mortgage Broker
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