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Why does the Bank of Canada adjust interest rates?

Inflation and interest rates are predicted to reach highs not seen in decades, and that has many concerned people and businesses wondering, what is the relationship between inflation and interest rates, and how is the Bank of Canada involved in all of this?

If you’ve found yourself wondering the same thing, don’t worry. We’re here to help. In this article, we’ll help you understand this complex topic by answering the following questions:

1. What is the Bank of Canada and what does it do?

2. How does it adjust interest rates?

3. Why does it adjust interest rates?

Make sure to speak with a Coast Capital financial advisor to learn more about how your personal financial plans can be affected by inflation and changing interest rates.

1. What is the Bank of Canada and what does it do?

Founded in 1934, the stated mission of Canada’s central bank is “to promote the economic and financial welfare of Canada.” It works to achieve this goal by:

  • Promoting safe, efficient, and transparent financial systems and institutions in Canada.
  • Designing, printing, and circulating Canadian banknotes (with coins being produced and distributed by the Royal Canadian Mint).
  • Managing the public debt and foreign exchange reserves of the Government of Canada.
  • Monitoring payment services providers to ensure their confidence and reliability while protecting everyday people and businesses.

One of the Bank of Canada’s most important functions is keeping inflation within an ideal mid-range target of 2%, with high-end figures not exceeding 3%.

2. How does the Bank of Canada adjust interest rates?

The Bank of Canada adjusts interest rates for the rest of the Canadian economy by raising or lowering what is called the overnight rate. Here’s why.

Like any other kind of business, banks and financial institutions often need to take out short-term, even single-day, loans in order to keep their operations going, and they get these loans from each other. These loans are like any other in that they charge the borrower interest that is paid to the lender. The interest on these kinds of loans is called the overnight rate, and the Bank of Canada can make changes to it.

When inflation is high, the Bank of Canada will increase the overnight rate.

3. Why does the Bank of Canada adjust interest rates?

The Bank of Canada adjusts interest rates to keep inflation under control. To understand why, let’s first look at what inflation is, before explaining why

Inflation occurs when a currency’s purchasing power, or its ability to buy products and services, decreases. It’s caused when the costs of producing and shipping those products and services rise, usually as a result of increased demand for them from consumers.

One of the ways the Bank of Canada combats inflation is by raising interest rates. The thinking goes like this: if interest rates rise, savings and investing money will become more attractive than simply spending. At the same time, the interest rates on loans will increase, too, requiring people and businesses to spend more and more on borrowing. Many will choose to borrow less, curb spending, and do their best to save more, instead of using loans.

According to this thinking, the demand – and therefore the prices – for goods and services will begin to decrease as more and more businesses and everyday Canadians opt to save and invest their money, rather than spend it. This will push inflation back towards more manageable levels.

As for why the Bank of Canada focuses their efforts on overnight rates when making changes to interest rates generally, just remember that the Bank of Canada is tasked with balancing reasonable inflation rates and long term economic growth. High inflation rates can cause more damage to long term economic growth than will be caused by increasing interest rates.  Though it’s more art than science, The Bank of Canada has to find that right balance.

How will your finances be affected if the Bank of Canada changes the interest rate again?

Everyone’s financial situation is unique. The financial advice you receive should be unique, too. That’s why you should speak to a Coast Capital advisor, if you’re concerned about how inflation and rising interest rates can or will affect your financial plans. Speak with a trusted and dedicated advisor who will take the time to understand your unique needs and goals when you visit a Coast Capital branch or call us at 1.888.517.7000

 

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This article is provided for general information purposes only. It is not to be relied upon as financial, tax, or investment advice or guarantees about the future, nor should it be considered a recommendation to buy or sell. Information contained in this article, including information relating to interest rates, market conditions, tax rules, fees, and other investment factors are subject to change without notice and Cost Capital Savings Federal Credit Union is not responsible to update this information. All third party sources are believed to be accurate and reliable as of the date of publication and Coast Capital Savings Federal Credit Union does not guarantee accuracy or reliability of such sources. Readers should consult their own professional advisor for specific financial, investment, or tax advice, tailored to their needs, to ensure that individual circumstances are considered properly and action is taken based on the latest available information.

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