Why Are Interest Rates So High?

The main tool or mechanism that the BoC uses to control inflation is the target for the overnight rate, also called the policy interest rate. The overnight rate is the interest rate that banks can use to borrow and lend from one another in the overnight market.

Throughout each day, banks move money between each other, whether it’s by a debit transaction or an Interac e-Transfer. At the end of each day, banks need to settle these transactions. If a bank sends out more money than it receives, its balance sheet will be short for that night; if it receives more than it sent out, then it will have a surplus. To balance out these payments, banks can borrow money from each other in the overnight market.

Banks can also borrow money from the BoC, depositing money at the deposit rate for one night, or borrowing money at the bank rate. The range between the deposit rate and the bank rate is called the operating band, and it can vary in size. Currently, the operating band is 0.25%, with the deposit rate equal to the target rate. This is called a floor system, because the target is the floor of the operating band.

As the policy interest rate is currently set at 5%, the deposit rate is also 5% and the bank rate is 5.25%.

Prior to 2020, the Bank had an operating band of 0.5%, with the policy interest rate sitting in the middle. So, using the current policy interest rate of 5%, the deposit rate is 4.75% and the bank rate is 5.25%.

While these rates don’t affect Canadians directly, they do impact other kinds of borrowing, including:

• The prime rate of commercial banks, used for loans such mortgages and lines of credit
• The interest paid on deposits, GICs and other savings

Over the years, the Bank has used different mechanisms for setting the bank rate, alternating between a fixed rate and a floating rate (set above the average yield on 3-month treasury bills). Then in June 1994, the Bank shifted from using the bank rate as its key monetary policy instrument to using the target for the overnight rate. In December 2000, the Bank began setting the level of the bank rate, and with it the target for the overnight rate, on eight fixed dates per year.

Why Does the Bank of Canada Change the Target Rate?

It’s widely known that the Bank changes interest rates to control inflation, by raising rates when the economy is growing too fast and becoming overheated, and lowering rates to stave off a recession and encourage spending. The inflation-control target was first adopted by the Bank in 1991, and currently sits at 2% (the midpoint of a target range of 1% to 3%).

Raising the interest rate has multiple effects, including:

• Consumers and businesses pay higher interest on loans and mortgage, which discourages borrowing
• Consumer and businesses spend more money servicing their debt, which reduces spending
• With higher rates, consumer tend to save more and spend less, which slows down the economy

Changes to the policy interest rate usually take between 12 and 18 months to impact the economy.

In a February 2024 speech in Montreal, Bank of Canada Governor Tiff Macklem shared his thoughts on the effectiveness of monetary policy: “Monetary policy works to control inflation—not perfectly, not quickly, and not without pain. But it works. History, including recent history, has shown us that.”

He added that “the rate of inflation averaged very close to 2% over the 25 years prior to the pandemic, and inflation and economic activity were much more stable.”

The History of the Overnight Target Rate

Taking a look at the history of the overnight target rate provides some context for the situation we’re in now.

In the mid-1990s, the target rate reached a high of 8.125%.  Then, in response to the country’s sluggish economy, the BoC cut the target rate by 475 basis points between May 1995 and October 1996, bringing it to 3.25%.

In the late 1990s, stock markets soared— until the dot-com bubble burst and the TSE lost one-third of its value. In response to fears over another 1929-esque recession, the Bank cut rates from 6% to 4.25% in the summer of 2001. After 9/11, the Bank cut rates to 2.25% in early 2002. These cuts helped Canada avoid a recession and inflation numbers stabilized.

There was some upward movement with the target rate leading up to the 2007 to 2008 financial crisis, but by the end of 2008, the overnight rate was once again down, this time to 1.5%. The Bank cut rates to 1% in late January 2009, 0.5% in March 2009 and 0.25% in April 2009.

For over 10 years, the overnight target rate stayed under 1.75%. And then the pandemic hit, and entire sectors of the economy were shut down overnight. The Bank responded quickly, cutting the overnight rate to 1.25% from 1.75% on March 4, 2020, and again on March 16 to 0.75%. By the end of March 2020, the overnight rate was at 0.25%, where it stayed until March 2022. Since then, the Bank hiked its policy interest rate 10 times in 17 months.

In his speech, Mackem characterized the pandemic as “the biggest shock so far,” adding, “The pandemic experience is different than the previous shocks—monetary policy had to respond first to the threat of deflation, and then to rapidly rising inflation once the economy reopened. Our mandate is symmetrical—we are just as concerned about inflation that is too low as we are about inflation that is too high.”

It’s unlikely. The Bank of Canada keeps step with the U.S. Federal Reserve, which has also steadily raised interest rates since March 2022 hiking its rate 11 times to quell inflation, the last increase in July 2023. With inflation slowing from over 9% to 3.1% in January 2024, the Fed is expected to hold rates before cutting them later this year.

Since July 2023, the BoC  has held steady on the policy rate, keeping it at 5%.

According to its January 2024 Monetary Policy Report, the Bank notes that “interest rates are working to moderate spending and inflation is easing gradually, though underlying pressures are proving persistent.” Notably, shelter inflation continues to put upward pressure on the CPI, due largely to high mortgage interest rates and expensive rent.

At the time the Bank projected that inflation will stay around 3% through the first half of 2024, returning to target in 2025. As long as core inflation continues to ease, there is no reason to believe the Bank will need to hike rates again.

The next overnight interest rate announcement will occur on June 5, 2024. (You can find the BoC’s full schedule here.)

As noted, the BoC’s interest rate hikes are meant to curb inflation, and it’s working. Inflation has eased to 2.9% as of March 2024, significantly less than its peak of 8.1% in June 2022.

In its most recent key interest rate announcement, the BoC held interest rates steady at 5%, as expected. Market consensus is that the Bank start a series of rate cuts in Q2 or Q3 of 2024.

However, inflation remains above target in most countries. Economists at Desjardins note in a February 2024 report that “The odds of additional interest rate hikes have dropped significantly, but interest rate cuts could be delayed if progress on inflation stalls.”

The report notes other potential inflationary shocks that are currently in play, including shipping disruptions in the Red Sea, mortgage renewals at significantly higher rates and fewer exports if the global economy gets stuck in a “major rut,” could also delay rate cuts.

While high interest rates can be stressful for Canadian households, history shows that what goes up also comes back down.