Bank of Canada increases overnight rate

Last week, the Bank of Canada announced that it was raising its target for the overnight interest rate by a quarter per cent to one per cent, predominantly to restrict growth on areas of spending that require borrowed money.

This will mark the third straight month of rate increases, which was previously set at 0.25 per cent during the economic downturn, by Canada’s central bank. This is suggestive that the Bank of Canada believes the Canadian economy is on the rebound, although GDP growth has been gradual.

“The Bank of Canada is acting to slowly restrict growth of demand on the portions of spending that are interest sensitive, like houses, cars and, to some degree, exports,” said David Johnson, professor of economics at Laurier.

Consistently raising interest rates signifies that the Bank of Canada believes low interest rates, that were set at zero at the start of the recession, are not needed to stimulate the Canadian economy.

Johnson believes that markets that will be most affected by an increase in the lending rate are those that are interest sensitive, primarily the housing and automobile markets. He also added that raising interest rates could potentially curb demand for items in these particular markets and others that are financed with borrowed money.

Other banks, however, are still skeptical about the rosy outlook the Bank of Canada has promoted regarding the Canadian economy. While the rate increase was predicted, it has not garnered unanimous support from other financial institutions.

“Poor housing sales and less spending by Canadians is still making for a fragile economy and higher borrowing costs won’t help improve the situation,” said BMO economist Douglas Porter.

This sentiment on the fragility of the Canadian economy is shared by Craig Alexander, TD’s chief economist, who stated in a press release that the “high indebtedness of Canadian households is also likely to act as a serious constraint on spending even in a continuing low interest rate environment.”

Those who do support the Bank of Canada’s increase of the overnight rate are speculating whether or not the gradual increase is aggressive enough given the recent growth in the Canadian economy, especially with the inflation rate constant at two per cent.

“The goal is to be predictable and gradually raise interest rates. Assuming that the target rate of inflation remains around two per cent, we would expect the average interest rate to be greater than two per cent,” Johnson explained.

Whether or not the Bank of Canada will hold off on raising interest rates, as many have predicted, will depend on the economic performance over the next quarter. Support for the rate increase has been split amongst financial institutions as borrowing money will now become more expensive.

Such a divide in support for the rate increase paints an unclear picture of the Canadian economy in terms of growth rate increases and whether or not government stimulus has created long-run, sustainable demand.

“It is hard to see a nominal rate of one per cent as sustainable forever,” said Johnson.

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