What changes interest rate

INDEPTH: ECONOMY
Interest rates: The rising cost of money
CBC News Online | Updated June 29, 2006


What goes down must – when it comes to interest rates – eventually go up. These days, consumers and businesses in both Canada and the United States are noticing an unmistakable upward trend that began in 2004. In that year, central banks in both countries put an end to a long series of rate cuts that took interest rates to 40-year lows.

By June 2006, the Bank of Canada had hiked its key overnight lending rate nine times to 4.25 per cent. Its American counterpart, the Federal Reserve, had raised its key rate no fewer than 17 times to reach 5.25 per cent.

The movement of American rates is critical to what happens on this side of the border. According to the Bank of Canada:

"Interest rates in Canada are broadly determined by the level of interest rates in the United States, the relative inflation rates in both countries, and the relative stances of their monetary policies. A risk factor is also factored in. The result is that Canadian interest rates can be either higher or lower than U.S. rates but are never fully independent."

The Canadian economy also does not necessarily follow the American economy as it expands or contracts. When the Canadian economy is doing better than the American economy and inflation remains under control, the central bank may not have to follow every move the American central bank makes.

Why change interest rates?

Think of money like any other commodity where the price is determined by supply and demand. When the Bank of Canada changes its key lending rate, it’s changing the supply of money (or “monetary stimulus” in bank-speak). Making money more expensive to borrow reduces monetary stimulus because it reduces the demand for money. The Bank does this when it’s worried about rising inflationary pressures in an overheated economy. The central bank’s main way of keeping inflation in check is by hiking its benchmark lending rate. The best way to jump-start a stagnant economy is by making it cheaper to borrow money – a stimulative move.

Does the Bank of Canada set all interest rates?

No. The Bank of Canada sets the "target for the overnight rate." The overnight rate is the interest rate that banks charge each other to cover their short-term daily transactions. The target for the overnight rate is a half-percentage-point band.

If, for instance, that band is 3.25 per cent to 3.75 per cent, it means that banks will charge 3.75 per cent interest on money they lend to other banks and pay 3.25 per cent interest on money deposited by other banks.

The chartered banks use the overnight rate as a guide in setting their prime lending rate – the rate at which the bank's best customers can borrow money. When the central bank changes its overnight rate, it's sending a signal to the chartered banks that it wants them to change their prime lending rates. The banks always follow suit; if the central bank raises its overnight rate and a bank leaves its prime rate unchanged, it will make less profit.

The Bank of Canada does not directly set mortgage rates or credit card rates. Variable mortgage rates and other floating rate loans like lines of credit move up and down in lock step with the prime lending rate. But the rates for fixed mortgages depend more on the bond market. Banks rely on the bond market to raise money for those kinds of mortgages. Interest rates on the bond market can move up or down more frequently than the prime rate because the bond market is far more sensitive to market fluctuations. Rates move when traders believe the central bank may be about to increase – or reduce – interest rates.

Credit card rates, on the other hand, hardly budge at all. Most cards carry an annual interest rate of around 19 per cent. Department store and gas cards are often around 28 per cent. The higher rate, according to the Canadian Bankers Association, is attributable to risk. A mortgage is a secured loan because the loan is backed up with a tangible asset: your house. Using a credit card is essentially taking out an unsecured loan because there is nothing physical used as security for the lender. In addition, the CBA says, credit cards are much more susceptible to fraud, which necessitates an interest rate that remains consistently high.

What happens when rates go up?

It goes without saying that it costs more to borrow money when interest rates increase. This doesn't have much of an impact on most day-to-day buying decisions. But if you're in the market for a house, you might think twice about buying as rates rise. For instance, if you need a $200,000 mortgage – which is not uncommon now that you can buy a home with essentially no down payment – you would be paying $1,163.21 every month in principal and interest for 25 years, if your mortgage interest rate was five per cent.

But if that rate was just one percentage point higher, your payments would be $1,279.62 per month. And that doesn't include property taxes. Bump the rate to seven per cent and your payments are just over $1,400 a month. Might be enough to make you think twice about buying.

And if you don't buy, then those big box hardware stores might not see as much of you since you won't be renovating that new house. Same goes for the furniture stores that wanted to sell you that entertainment unit for the new home theatre you were thinking of installing.

On the other hand, if you've paid off your mortgage and have a whack of cash lying around, higher rates mean the bank will pay you more to let your money sit with them in savings accounts or GICs.

The central bank moves to higher rates when it believes the economy is in danger of growing too rapidly. Rapid economic growth could cause a cycle of rising prices and wages. The central bank wants that growth to be moderate, so inflationary pressures are kept in check.

What happens when rates go down?

The simple answer is, of course, that the cost of borrowing goes down. But there's method behind the manoeuvring. Lower rates are an unmistakable signal from the central bank that it's worried that the economy is weakening and people aren't buying enough big-ticket items. Lowering rates helps to spur economic growth because it makes it more attractive for businesses and consumers to borrow. The central bank must be careful not to inject too much stimulus into the economy or it risks igniting inflation. Correctly forecasting this balance of risks is the central bank’s most difficult and most important task.

When are interest rates set in Canada?

The Bank of Canada sets rates eight times a year – in late January, early March, mid-April, late May, mid July, early September, mid-October and early December.

The Bank retains the option of taking action between fixed dates, but only under extraordinary circumstances.

The U.S. Federal Reserve also sets rates eight times a year. The Bank of England sets rates 12 times a year.