BoC leaves key interest rate unchanged. Why is this important?

As many leading economists and all 6 big banks predicted, the Bank of Canada has kept the overnight rate at 1.25%. As with all macro-economic choices, this decision has been made due to numerous factors. In this article, we explore why all this rate nonsense matters to every Canadian household, why the BoC has left interest rates unchanged, and what to expect throughout the year.

Why do interest rates matter?

To many, an interest rate announcement barely even gets noticed as one scrolls through their facebook newsfeed but this percentage is of upmost importance to almost every household. Why? It is used to calculate the cost of borrowing and return on savings throughout the economy which includes:

·       Mortgages

·       Credit cards

·       Car loans

·       Savings accounts

It’s also an indicator of how well the economy is performing. As rates rise, we can generally assume that the economy is performing well and inflation is near 2%.

Pay attention to interest rates to gain insight into what’s going on in the economy and what to expect in the future.

Terminology Debunked

Before we get into the details, it’s important to understand the keywords used when discussing interest rates, and have a basic understanding of how they work.

Interest Rate – Rate at which banks calculate your cost of borrowing money or your income from savings. It is typically shown as a percentage applied to the outstanding loan or the deposit balance.

Overnight Rate – The lowest interest rate in Canada, it is used to calculate the cost when one bank lends to another bank for one night (Hence overnight rate). The targer for this rate is set by the Bank of Canada and it can be thought of as the base rate at which all the others are set against.

Bank Rate – The interest rate at which the Bank of Canada lends money to Canadian domestic banks.

Yield Curve – This shows the relationship between interest rates and how long money is being loaned for, at one level of risk. The riskless yield curve is the lowest in the Canadian economy and is used to calculate interest on loans between domestic banks and the BoC, and it is the rate that the Canadian Government pay on our national debt. Every other yield curve is set above the riskless curve, with the distance from the base rate determined by the riskiness of the loan.

As you can see the prime yield curve (what’s used to determine your mortgage rate) is above the riskless curve. This is because the risk involved in lending to those on the prime rate curve is higher, naturally a bank is more likely to pay back a loan than a single person who has bought a house.

Why has the Bank of Canada kept the overnight rate unchanged?

Yesterday, the BoC announced that the overnight rate would be held at 1.25% in a blunt and unusually short statement to the markets.

They did this because the economy has performed better than expected in the beginning of the year. In particular, exports to the U.S. (Canada’s biggest trading partner) were “more robust than forecast”.

However, uncertainty hangs over our trade relationship with the U.S. and global oil prices. The housing market started the year poorly and has stayed cool going into the second quarter. The industry is still adjusting to tighter mortgage regulations and higher interest rates.

In summary, the economy is performing well and inflation isn’t too high so there is little need to play around with the Overnight Rate for now.

Finally, inflation is trending slightly above the 2% target and will likely move higher through the year. This is, by and large, because of increasing gasoline prices. The BoC cites rising inflation as the reason to expect interest rate increases through the rest of the year.

What do we think will happen?

In the statement, the Bank made it clear that markets should expect interest rates to rise in coming rate announcements (The next is on July 11th). This is largely because the bank will want to cool off inflation to keep it around the magic number of 2%.

Interestingly, there was a change in language used to describe the expected future changes. Previous statements had focussed on “cautious” changes but the adjective switched to “gradual”, suggesting that we should expect small incremental increases in interest rate for the foreseeable future. This, of course, is assuming the economy performs strongly as we move into the summer.