The Bank of Canada just raised interest rates. Here’s what it means for your finances and the economy

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The Bank of Canada raised its benchmark interest rate to 0.5 per cent on Wednesday, the first in a series of hikes that are expected this year and next. Here are the implications of that move.

What exactly is this interest rate – and why is it important?

The Bank of Canada raised its target for the overnight lending rate. This is what the central bank wants financial institutions to charge their peers for overnight loans. But more importantly, it is the fundamental interest rate in the economy – and as it moves up or down, it affects the cost of borrowing for mortgages and other loans, and what’s paid on deposits and other savings.

Early in the COVID-19 pandemic, the Bank of Canada slashed its overnight lending rate – also known as the policy rate – to 0.25 per cent, matching record lows seen about a decade earlier. The idea was to drive down borrowing costs and stimulate activity in a battered economy. Other central banks did the same. Now, the case for emergency levels of stimulus has ended.

Why is the Bank of Canada about to hike?

Simply put, the country’s economic health is much improved. More Canadians are employed today than two years ago. In dollar terms, trade with other countries has rallied to record amounts. And households are spending freely, helped by a massive build-up of savings.

There is, however, a danger lurking: inflation. The country’s annual inflation rate recently hit a 30-year high of 5.1 per cent. That’s where the Bank of Canada comes in: Its primary goal in setting interest rates is to keep inflation around 2 per cent, with some wiggle room on either side. The bank has largely chalked up higher inflation to temporary factors that are pushing up prices, such as supply disruptions. But there are signs that steeper inflation is at risk of becoming entrenched – hence why the bank is acting now.

In practice, higher interest rates will make it more expensive to borrow, which typically cools demand, helping to drive inflation lower and toward the bank’s 2-per-cent target. The effect is not immediate, however. The Bank of Canada says it takes about 18 to 24 months for the full effect of interest rate changes to occur. Moreover, rate hikes are not doled out all at once, instead taking place over a period of months or even years.

How many rate hikes are coming?

That depends on whom you ask. Some banks are projecting three or four rate hikes – each amounting to one-quarter of a percentage point – this year. Others think there will be more action. Bank of Nova Scotia envisions seven rate hikes this year, followed by two more in 2023, taking the policy rate to 2.5 per cent. The overnight lending rate hasn’t been that high since it was being cut in the Great Recession of 2008-09.

When will inflation slow down?

That’s tough to predict. Supply-chain snarls are dragging on, while gasoline prices – an outsized factor in higher inflation – have been rising in recent weeks, on account of the Russia-Ukraine war. Other commodity prices, such as wheat, are also surging because of the conflict.

Regardless, central bankers expect inflation rate to ease this year. In January, the Bank of Canada projected the annual rate of inflation will ebb to around 3 per cent by the end of 2022. Of course, that doesn’t mean the central bank will be right – it has consistently underestimated the path of inflation over the pandemic. As recently as October, the Bank of Canada said inflation would ease to around 2 per cent by the end of this year. Despite the upward revisions, financial analysts tend to agree that inflation should wane over the coming year.

Keep in mind, a slowing of inflation to 2 per cent from 5 per cent does not mean that average prices would decline – merely that the pace of growth would decelerate.

How financially vulnerable are Canadians to higher rates?

Canadian families are among the world’s most indebted, an issue that pre-dates the pandemic. On average, households have $1.77 in debt for every dollar of disposable income, a ratio that is near a record high. Household debt of $2.7-trillion in December was the most ever, jumping by $284-billion over the last two years. The increase was solely driven by a steep uptick in mortgage debt, which is closing in on $2-trillion. With mortgage rates hitting all-time lows in the pandemic, that helped to fuel a frenzy of home transactions.

Those details, while troubling, don’t necessarily spell doom. Home buyers must pass a stress test of their ability to pay their mortgages at higher rates. Still, those heftier payments would eat into family budgets, potentially affecting how they could spend in other areas.

How much higher would mortgage payments be?

It depends on the buyer, but here’s an example. For someone with a $500,000 mortgage amortized over 25 years at a 2.5-per-cent rate, the monthly payment would be $2,240. Five years later, if the mortgage was renewed at 3.5 per cent, the monthly payment would increase $209 to $2,449. If instead the mortgage rate was 4.5 per cent, the monthly payment would be $2,668 – a difference of more than $5,000 over a year’s worth of payments.

How will real estate be affected?

As always, the trajectory of Canada’s housing market is the subject of much debate. It does, however, seem unlikely that a record-setting pace of transactions can last much longer.

“Our view is the anticipation of higher rates is already impacting the market: currently bringing some activity forward as buyers hurry to lock-in lower rates,” Robert Hogue, senior economist at Royal Bank of Canada, wrote earlier this year in a report. “This phenomenon should reverse by mid-year and work to cool demand.”

For hopeful buyers, the question is whether homes become more affordable. The typical home price has surged 46 per cent (or roughly $265,000) over the last two years to about $836,000. The Canadian Real Estate Association (CREA) forecasts the average sale price in 2022 will be higher than last year, though not increase at nearly the same pace. There is very little inventory of available homes, helping to prop up prices.

“Residents shouldn’t expect home price growth to relent until there’s a more adequate supply of housing available to purchase,” Keith Stewart, economist at the Real Estate Board of Greater Vancouver, wrote in a recent report of the area.

What will happen to the Canadian dollar?

Central bank activities have a large impact on currencies. When the Bank of Canada raises its policy rate, the Canadian dollar may rise in value, making our exports more expensive for buyers in other countries (and conversely, make imports cheaper). That said, other factors are at play – among them, activities at the Federal Reserve, the U.S. central bank. The Fed is also planning to raise interest rates several times this year.