Interest rate hike in Canada
Interest rate hike in Canada
The central bank of any country is responsible for maintaining stability in the financial system. The central bank is also responsible for implementing the fiscal policy planned by the government. Certain tools are available to help the Bank fulfill its role. Control of 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. Generally, in any country, 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 usually granted overnight. The interest charged by the central bank is the cost of borrowing for financial institutions.
What happens when the discount rate changes?
The discount rate is used by the Central Bank to encourage or discourage borrowing by financial institutions, which consequently has an impact on the supply of credit in the country. When the cost of borrowing changes for the bank, it affects the interest rate that financial institutions charge their customers. The intention of changing the discount rate is to impact 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, which results in a decrease or increase in consumer spending in the economy.
canadian perspective
The Bank of Canada raised the country’s discount rate from 1.25 percent to 1.5 percent in the past week. This was the fourth increase in the last 12 months. Inflation is expected to rise to 2.5% before hovering around 2% again 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 interest 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, etc. But any variation in the prime rate invariably has an effect on the final rate.
What will change for Canadians?
1. The cost of borrowing will rise: 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. Increased mortgage interest: Home buyers request mortgage loans with fixed or variable interest rates. New mortgages invariably get more expensive as banks’ prime rates rise, but it also hits existing borrowers with variable rates. Your mortgage payments increase in line with the rate increase. Existing fixed rate mortgages are not affected by the increase in discount rates, but the expected increases and risks are already taken into account when such mortgages are extended.
3. Declining home sales: Rising mortgage rates discourage people from buying new homes and consequently cool the housing market. Most people view a home purchase as a long-term investment, and any increase in the mortgage not only makes it less affordable, but also reduces the return on your investment.
4. Greater incentive to save: Rising prime rates also affect the savings rates offered by banks and give people more incentive to save rather than spend.
5. Lower consumer spending: Higher interest rates reduce consumer spending and investment and cause aggregate items to fall. Lower demand reduces economic growth and eases inflationary pressures on the economy.
6. Increased currency value: Due to rising interest rates, investors are more likely to save, and may result in increased investment inflows 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 reduce the confidence of businesses and consumers alike. It makes them less willing to invest and risky purchases.