Interest rate increase in Canada
Interest rate increase in Canada
The central bank of any country is responsible for maintaining the stability of the financial system. The central bank is also responsible for implementing the fiscal policy planned by the government. There are certain tools available to help the Bank fulfill its role. Controlling the discount rate is one of the tools in the central bank’s arsenal.
What is the discount rate?
The Central Bank is considered a lender of last resort. In any country, typically, financial institutions borrow from the central bank to stabilize their liquidity situation. The discount rate is the interest rate charged by the central bank to borrowing financial institutions. These are short-term loans that are generally granted overnight. The interest charged by the central bank is the cost of borrowing from financial institutions.
What happens when the discount rate changes?
The discount rate is used by the Central Bank to encourage or discourage the indebtedness of financial institutions that consequently have an impact on the country’s credit supply. When the cost of loans changes for the bank, it affects the interest rate that financial institutions charge their customers. The intention of changing the discount rate is to affect the money supply and therefore consumer spending in the country.
Since the interest charged by the financial institution depends on the cost of the loan, any change in the discount rate affects the interest charged on credit cards, overdrafts, loans, mortgages or any other form of credit granted to customers that results in decreasing or increase consumer spending in the economy.
Canadian perspective
The Bank of Canada raised the country’s discount rate from 1.25 to 1.5 percent in the last week. This was the fourth increase in the last 12 months. Inflation is expected to rise to 2.5% before returning to around 2% in the second half of 2019.
Following the Bank of Canada rate hike, the big five banks also raised their prime rates to 2.95%. The prime rate of any bank becomes the basis for calculating the interest rate of any product offered by the bank to its customers. There are other factors that determine the interest rate of a product such as risk factors, credit history, collateral guarantees, etc. But any change in the prime rate invariably has an effect on the final rate.
What will change for Canadians?
1. The cost of loans will increase: New credit will become more expensive, discouraging people from borrowing and spending more money. Spending will generally be reduced, which will ultimately help ease inflationary pressures on the economy. Companies also postpone expansions and other borrowing plans if the expected investment is not expected to generate sufficient returns.
2. Increase in mortgage interest: Home buyers can apply for mortgage loans with fixed or variable interest rates. Any new invariable mortgage becomes more expensive with the increase in bank prime rates, but it also affects existing borrowers with variable rates. Your mortgage payments increase in line with the rate increase. Existing fixed-rate mortgages are not affected by rising discount rates, but the expected increases and risks are already taken into account when these mortgages are extended.
3. Decrease in home sales: Rising mortgage rates discourage people from buying new homes and consequently cools down the housing market. Most people view buying a home as a long-term investment, and any increase in the mortgage not only makes it less affordable, but also results in a reduction in the return on your investment.
4. Greater incentive to save: Increasing prime rates also affects savings rates offered by banks and provides more incentives for people to save rather than spend.
5. Lower consumer spending: Higher interest rates reduce consumer spending and investment and cause a drop in aggregate dements. Lower demand reduces economic growth and eases inflationary pressures on the economy.
6. Increase in the value of the currency: due to the increase in interest rates, investors are more likely to save, which can result in an increase in the entry of investments into the country, which will increase the value of the currency . Exports will become less competitive and imports will increase.
7. Reduced confidence: rising interest rates reduces the confidence of businesses and consumers alike. It makes them less willing to make risky purchases and investments.