Interest rates and inflation — a beginner’s guide

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Why the Bank of Canada keeps raising interest rates.

Hearing a ton about interest rates and inflation lately? If you’re not quite sure what everyone’s talking about, then you’ve come to the right place. In beginner-friendly terms, we’ll explain the logic behind the Bank of Canada’s recent interest rate hike – and what it all means for you.

 

 

How am I affected when the Bank of Canada changes the interest rate?

The Bank of Canada uses something called the policy interest rate (also called the overnight rate) to control inflation. The overnight rate is the rate banks charge each other for loans in the overnight market — we’ll explain why in a minute.

When the Bank of Canada changes the policy interest rate, a chain reaction occurs that influences lending rates from commercial banks – which directly affects you.

Generally, when the overnight rate declines, you can borrow more with less interest (i.e. debt is less expensive) and you earn less interest on your savings (i.e. saving is less lucrative).

The reverse of this is also true. When the overnight rate increases, it’s more expensive for banks to borrow money, so the cost gets passed onto you through higher interest rates on mortgages or lines of credit (i.e. debt is more expensive) and saving is incentivized through higher interest rates (i.e. saving is more lucrative).

 

So how does this fight inflation?

 

 

Through supply and demand! Don’t worry, you don’t need to be an economist to understand this.

First, two key definitions: 

Low inflation – When the price of goods and services increases slowly over time.

High inflation – When the price of goods and services increases quickly over time. 

In response to low inflation, the Bank of Canada might slash the overnight rate to boost economic activity. As a result, borrowing rates at commercial banks for mortgages and loans (and interest rates on savings accounts) tend to fall.

When interest rates are low, it’s easier to borrow and spend money. Generally, low interest rates mean people are willing to buy more goods and services, so demand is high. High demand strengthens the economy, raises prices, and moves inflation up to target.

On the other hand, the Bank of Canada might raise the overnight rate to bring inflation back down. If it becomes too expensive to get a loan or pay off your credit card, you’re probably going to borrow less and also spend less. When less people are willing to buy something, demand is low. When demand is low, prices go down – resulting in lower inflation rates.

This is why the Bank of Canada raised the policy interest rate to 1% in April of 2022, the highest rate since 2000. It was fighting the high level of inflation in March of 2022 — a record 6.7%.

With all these record highs, it’s no wonder you’re hearing so much about it.

Let’s take a step back and fully explore everything that’s happening here.

 

What exactly is inflation?

 

 

Inflation is an increase in the price of goods and services over time. Because of these increases, the value of your dollar actually decreases over time – and so does your purchasing power. For example, $100 today cannot buy the same amount of stuff it could buy five years ago.

To calculate the rate of inflation, economists use something called the Consumer Price Index (CPI). The CPI looks at a “basket” of goods and services the average Canadian would buy and compares the cost of this “basket” last month (ex. April 2022) with the same month a year earlier (ex. April 2021).

Say the average household spent $100 on chicken, bananas, chocolate, and crackers one month and spent $105 a year later on the same goods. The inflation rate for this household would be 5%.

When inflation goes up, the same goods and services cost more money; essentially, everything becomes more expensive. Some inflation is always expected, but the Bank of Canada aims to keep the inflation rate around 2% by changing the target for the overnight rate.

 

Why does this matter?

When prices go up and money can’t buy as much as it used to, the loss of purchasing power hurts everyone’s standard of living. High inflation rates can mean uncertainty for individuals and businesses because costs become unpredictable from one day to the next. This prevents the economy from performing at its best.

Another challenge of high inflation is that incomes often don’t rise enough to keep up with increasing prices, making it especially hard to afford even basic necessities. High inflation essentially decreases the value of income and savings.

Low, stable, and predictable inflation is good for your finances and the economy as a whole. Average economic growth is stronger, employment is higher, and money keeps its value better – which makes it easier for everyone to build long-term financial plans.

 

What’s an interest rate?

 

 

Think of interest as the price of getting money today with the promise to pay in the future. For example, you and your friend go out to dinner and they forget their wallet. They ask you to borrow $20 and say they’ll give you $25 tomorrow for being such a good friend. The extra $5 you’ll get tomorrow is what your friend paid you in interest.

So, the proportion of extra cost you pay to borrow money is your interest rate. In our example, your friend's interest rate would be 25% — calculated by dividing their interest of $5 by the original $20 cost.

That’s basically how all interest rates work, like the one on your credit card, student loan, or mortgage, and even the overnight rate that’s set by the Bank of Canada.

By the way, money in your savings account also earns interest because you are essentially lending that money to the bank.  

 

What does the Bank of Canada do?

 

 

The Bank of Canada is Canada’s central bank. It acts as a research institution, monitoring the economic factors that affect the value of the Canadian dollar, and sets the overnight rate.

The most important responsibility of the Bank of Canada we covered today is:

  • monetary policy — preserving the value of money by keeping inflation low and stable

Other major responsibilities include:

  • financial system — making our financial systems stable
  • currency — designing and printing money
  • funds management — providing services to the Government of Canada like managing public debt
  • retail payments supervision — ensuring payment service providers (ex. currency transfer services or digital wallets) are following rules and regulations

The Bank of Canada is owned by the Canadian government and led by a council that carries out the responsibilities listed above. As a special kind of crown corporation, the Bank of Canada is somewhat independent from the Government of Canada.

There are a number of accountability practices to ensure the Bank is appropriately separate from political processes. For example, members of the council aren’t appointed by the federal government and the Deputy Minister of Finance (who oversees the Government of Canada’s Department of Finance) sits on the board of directors but has no vote.

Separation of central banks from political processes is important because it allows for the separation of the power to spend money from the power to create money.

 

What's the policy interest rate?

 

 

This is where things get a little more complicated than lending money to a friend.

As we already mentioned, the overnight rate, also called the policy interest rate, is the interest rate that major Canadian banks charge each other for overnight loans.

 

Why are Canadian banks loaning money to each other?

Every day, countless transactions are made by individuals, businesses, and investment funds. When you use your debit card or send an e-transfer, for example, money flows between different financial institutions. These payments need to be settled at the end of each day — some institutions may have sent more payments than they received and others may have received more than they sent.

In order to cover the cost of all these daily transactions, banks can borrow from each other for one day in the overnight market. The Bank of Canada sets the target overnight rate it wants banks to charge each other in this overnight market — commercial banks have zero control over the target overnight rate.

 

Recent changes to the overnight rate

The ability to change the overnight rate is a very important tool – changes to these rates can dramatically influence the overall economy, including factors like the unemployment rate, economic growth, and inflation.

The target for the overnight rate is adjusted on eight fixed dates each year.

In March 2020 at the beginning of the COVID-19 pandemic, the Bank of Canada lowered the target for the overnight rate twice as a proactive measure in response to sharp drops in commodity prices, specifically oil.

In March of 2022, Canada’s inflation rate rose to 6.7% — setting a record as the highest it’s been since 1991, which is why everyone’s talking about it.

In response, the Bank of Canada hiked their target overnight rate from 0.5% to 1% in April of 2022, setting another record as the biggest one-time increase since 2000. The Russia-Ukraine conflict, price spikes in commodities like oil and natural gas, and the ongoing effects of the COVID-19 pandemic all contributed to the high inflation rates that caused the hike.

We just threw a lot of information at you, so let’s sum it up.

 

The highlights

  • Inflation is the rise of prices for goods and services over time. Canada saw record high inflation at the beginning of 2022.
  • Interest is the price you pay to borrow money, and an interest rate is the percentage of the money borrowed that has to be paid on top of your loan as interest.
  • The Bank of Canada sets the target for the policy interest rate (also known as the overnight rate) commercial banks use when lending each other money.
  • When the overnight rate is changed to control inflation, commercial banks adjust their interest rates on services they offer you. An increase in the overnight rate results in an increase in interest rates
  • The overnight rate affects inflation through supply and demand.
    • High overnight rates (resulting in high commercial interest rates) are often used to reduce demand and lower inflation rates. This was the Bank of Canada’s response to high inflation at the beginning of 2022.
    • Low overnight rates (and low commercial interest rates) are often used to increase demand and raise inflation rates. This was the Bank of Canada’s response in early 2020 when the COVID-19 pandemic hit.

It’s important to understand interest rates and inflation so you can make informed financial decisions (or sound smart at the next dinner party you attend). 

However you decide to use your interest rate expertise, we hope this blog helped!

 

Melissa Atefi

Author