The Bank of Canada said today it is raising its benchmark interest rate by 25 basis points to 0.5%, the first increase since the pandemic began two years ago. The central bank’s move will have the follow-on effect of making it more expensive to borrow money from most lenders, such as for a home mortgage.

“Economies are emerging from the impact of the Omicron variant of COVID-19 more quickly than expected, although the virus continues to circulate and the possibility of new variants remains a concern,” the Bank of Canada noted in a statement released today. “Demand is robust, particularly in the United States. Global supply bottlenecks remain challenging, although there are indications that some constraints have eased.” 

The statement also mentioned that Russia’s invasion of Ukraine is adding to inflation by sending prices for oil and other commodities soaring and it could weigh on global growth. Nonetheless, the Bank of Canada said it would keep its holdings of Government of Canada bonds constant, at least for the time being. A move by the central bank to reduce these holdings could further tighten financial conditions by putting upward pressure on market interest rates. 

Financial institutions such as Scotiabank use the central bank’s headline rate as a guide to set their prime rate, the reference rate they use to define the costs for their customers to borrow money through loans, lines of credit, and mortgages. Scotiabank’s prime rate is available here

The central bank’s move was expected. Canada’s 0.5% rate is higher than the comparable 0.25% rate currently posted by the United States Federal Reserve, but the Fed is expected to issue its first rate hike in three and half years on March 16. Monetary authorities around the world are raising interest rates to fight the quickest inflation in decades. Canada’s January inflation rate of 5.1% year over year (y/y) was the strongest in more than 30 years, up from 4.8% y/y in December.2  Inflation is calculated on the consumer price index (CPI), which is based on the cost of a basket of representative goods and services purchased by an average Canadian household. 

The raising of interest rates – or the cost of borrowing – reduces demand for borrowed funds, tightens the money supply, and eventually causes price increases to slow or even reverse in some cases. Most Western economies have enjoyed interest rates at historic lows throughout the pandemic to help support businesses and households through shutdowns and restrictions on activity. 

“Along with nearly all forecasters, Scotiabank Economics anticipated today’s lift-off in the Bank of Canada’s principal policy rate,” Scotiabank Deputy Chief Economist Brett House says. “We expect the central bank to raise gradually its key rate to 2% by the end of 2022 and to 2.5% in the first half of next year.” Read more about Scotiabank Economics’ forecasts here. 

House says he foresees Canada’s inflation rate remaining above 3% y/y until late 2023. House thinks strong consumer demand and rising wages are unlikely to allow inflation to fall quickly enough to prevent further rate hikes from the Bank of Canada. 

“While everyone’s finances and risk tolerances are different, variable-rate mortgage holders should certainly consider looking at the costs and benefits of locking down a fixed rate,” House says. “Canadians should assess their options carefully with a Home Financing Advisor or their financial planner. 

What interest rate hikes mean for your mortgage 

Investors shouldn’t rush to make radical changes to their portfolios because of the interest rate increase, says House, who stresses he’s an economist, not a financial advisor, and does not give counsel on specific investment opportunities. 

“Risk assets, such as equities, typically see a pullback in their pricing at the start of central-bank hiking cycles,” the economist says. “But if we look back over the last 40 years of rate hikes, by six months after an initial rate increase stock indices had recovered their losses on nearly every occasion and were up compared with their levels weeks ahead of the interest-rate lift off.” 

A central part of the Bank of Canada’s mandate is the use of monetary policy tools, such as the setting of interest rates, to keep inflation at or around 2% y/y. The benchmark rate is also known as the overnight rate because it’s the price that financial institutions are charged to borrow money for one day. 

The COVID-19 pandemic has set-off manufacturing supply-chain disruptions in areas such as computer chips, while labour shortages in some industries owing to reduced immigration have spurred wage increases, driving up the prices of some products. Meanwhile, an intensification in climate-change events, such as droughts, has hurt output of food for people and grain to feed livestock. All of these factors contribute to the high inflation rates we see today. 

Most economists forecast that headline inflation rates are likely to recede over the coming two years. As supply kinks and transportation bottlenecks work their way out and the impact of the pandemic fades in more areas of the economy, many analysts project that inflation will return to an annual rate of around 2% y/y by 2024.3  They discount concerns that higher inflation is likely to become more entrenched, like it was in the 1970s after oil prices rose and costs sky-rocketed along with them. And, on balance, they believe that Canadians will be able to manage higher prices and interest rates. 

“Tight labour markets, rising wages, and relatively strong average household balance sheets should allow Canadians to cope with inflation and increased interest rates, but bigger pay packets could also keep inflation aloft a little longer than would otherwise be the case,” Scotiabank economist House says. 

“The fact that our central bank is ready to remove emergency policy support from the Canadian economy is, ultimately, a vote of confidence that our households and businesses are ready to sustain their recovery and growth following 2020’s shutdowns.”

Listen to the Perspectives podcast to hear from Scotiabank Chief Economist Jean-François Perrault on his reaction to today’s rate hike.

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