How does the Bank of Canada decide to raise or lower interest rates?

Borrowers, realtors, potential home buyers, and everyone else looking at the real estate market are all keeping an eye on the Bank of Canada’s decisions whether to raise interest rates, and by how much.

The key rate set by the Bank of Canada controls the cheapest cost of borrowing for banks, which in turn set’s the rate at which other financial firms can lend and borrow money. Lowering rates means capital is cheaper to borrow and money flows more freely through the economy. Conversely, raising rates makes debt less attractive, slows the flow of capital, and increases the return of bonds, GICs and savings accounts.

We know that interest rates are the primary tool with which the Bank of Canada attempts to control the economy, but how do they determine when to raise or lower rates, and by how much?

Recommended reading: Key terms from the Bank of Canada interest rate announcements

Let’s take a look at all of the factors that impact the Bank of Canada’s interest rate decisions.

Why is the Bank of Canada raising interest rates?

According to the Bank of Canada themselves their main goal is “to promote the economic and financial welfare of Canada.” and “to regulate credit and currency in the best interests of the economic life of the nation.”.

While this is a very broad goal that is open to interpretation, in practice the main goal of the Bank of Canada has been to keep the economy running strong while keeping inflation under a generally agreed upon target of 2% annually.

Inflation is a hotly debated topic and there isn’t agreement on the exact causes, with some arguing that currency creation from the central bank plays a large role, and others citing increased government spending, among a host of other factors. What is clear is that Canada has been facing an unsustainably high level of inflation in recent years, with the consumer price index (CPI) increasing a massive 6.8% in 2022. At that rate, the price of goods would double nearly every 10 years.

While deflation can lead to a stagnating economy and loss of businesses and jobs, high inflation has been known to devastate economies, lead to political unrest, loss of homes, and worse.

With inflation as high as it is currently, the Bank of Canada’s top priority is bringing the rate of inflation back down to their target of 2%, and their main tool is raising interest rates.

Why does raising interest rates lower inflation?

While the causes for inflation are hotly debated, it is clear that increasing interest rates, and therefore making it more expensive to borrow money, is an effective way to curb inflation.

When borrowing money is cheap, the demand for goods increases. Business owners will raise prices if demand goes up until a new equilibrium price and quantity point is established. If interest rates are high however, it decreases demand. Capital is more expensive so people take out less loans, and increasingly choose to save their money in assets such as bonds and GICs which provide increasingly attractive returns. When inflation is high, there are feedback loops that increase the cost of goods further. For example, if you know that the price of something will be more costly tomorrow than it is today, you should buy it now rather than wait till your savings are devalued further, and thus demand is increased, adding further inflationary pressure. 

When the central bank raises interest rates, they make it more expensive to borrow money, and therefore reduce the flow of money and reduce demand, which reduces inflation.

After a year of rate hikes, it’s clear that inflation is slowing in Canada, while still not yet at the desired 2% level.

How does the Bank of Canada determine if they’ve raised interest rates enough?

To determine whether or not their rate hikes are having the desired effect on inflation, the Bank of Canada looks at a number of economic signals to see how things are trending, including:

CPI

Of course the CPI, or Consumer Price Index, is the most important factor the Bank of Canada looks at when determining their monetary policy, as this is our measure of inflation. The CPI is a figure that measures the cost of goods and services in Canada and is our main gauge of inflation. If the CPI rate is slowing, this means the rate hikes are working and the Bank of Canada may be able to stop increasing rates sooner. On the other hand, if the CPI isn’t slowing then the Bank of Canada may determine they need to continue raising interest rates.

Employment

Another factor the Bank of Canada looks to when determining their policy is the job market.

A high level of unemployment isn’t a good thing, for businesses or the people who depend on their jobs to live, but unemployment is also a sign of decreasing inflationary pressure. If people don’t have jobs, they have less money to spend and therefore demand is lowered and so is inflation. The Bank of Canada has stated they are hoping to see an increase in unemployment as a sign their rate hikes are slowing the economy as hoped. 

GDP

GDP or Gross Domestic Product is a measure of the economic output of a country. Our GDP is a general measure of how strong or weak our economy is, and the higher our GDP per capita, the better off on average the standard of living is for Canadians. The Bank of Canada wants to curb inflation by decreasing demand, but their goal is not only to prevent high inflation but to manage the economy in general. Some economists are predicting that a recession (which is a prolonged period of decreased economic output) is unavoidable in order to reduce inflation. While the Bank of Canada needs to ensure that inflation is brought under control, they will likely take action in the other direction if inflation drops below 2% and the economy is facing a severe downturn.

With this in mind, aside from the CPI, the onset and impact of a recession in the economy could be a very likely predictor of when the Bank of Canada will reverse course and potentially start to decrease the key interest rate.

Bond rates

Generally bond yields follow the policy interest rate of the Bank of Canada who set the lowest cost of borrowing money for organizations like banks. When the market and bond traders believe that the Central Bank of Canada will increase rates, the Bond Yield increases and vice versa. In other words, the Bond yield is priced in anticipation of where the Central Bank of Canada rates will move. In this way, bonds are another economic indicator that analysts look at when trying to predict the market. While the bond market may not play a huge role in the Bank of Canada’s decision, they’re another indicator we can look at to try and predict which way rates are likely to trend in the future.

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