Keeping inflation stable and predictable is a key part of the Bank of Canada’s work to support the Canadian economy. The main way the Bank does this is through changes to its policy interest rate.
Inflation is the persistent rise in the average prices of goods and services over time. Think about the cost of new clothing and how the price goes up each year. Measures of inflation look at how fast that price grows, as well as the prices of other goods and services across the economy.
When inflation is high, firms need to spend more to buy raw materials and transform them into finished products. The costs to ship goods and operate retail stores also go up. All of that can push consumer prices even higher.
Prices that grow too fast make it harder for households to budget for groceries, fuel and other essential goods and services. High inflation is especially difficult for people with low or fixed incomes. That’s why keeping inflation stable and predictable for Canadians is so important.
The Bank sets a 2% inflation target because when inflation is near this level, prices are more stable and that helps the economy function better. The primary tool the Bank uses to control inflation is the policy interest rate. A higher rate helps decrease inflation and a lower one helps it rise.
How changes to the policy interest rate work
An increase in the Bank’s policy interest rate reduces demand for goods and services. That decreases inflation by slowing how fast prices rise, but this takes time to happen, usually about 12 to 18 months.
Here’s how it works: Canada’s financial institutions borrow money from one another to settle payments at the end of every day. The policy rate determines the interest charged on this lending, which then influences the rates financial institutions charge on things like mortgages and business loans.
Sectors of the economy that are most sensitive to changes in interest rates are the first to feel the effects of changes in borrowing costs. For instance, people often borrow money to make a large purchase like a new vehicle. An increase in the policy rate makes auto loans more expensive. Fewer people take out these loans, which decreases demand for vehicles.
With fewer vehicles being sold, production of new vehicles slows. That means less demand for auto parts, fewer hours for factory workers and lower pay for salespeople who earn commission. All of these workers have less money to spend and that decreases overall demand in the economy. Other sectors like housing and home appliances would feel similar effects.
How higher interest rates affect spending
Higher rates make it more expensive for people to maintain their existing debt. This reduces the amount of money that they have to spend and, over time, that reduces demand throughout the economy.
One example of how this works is people with variable rate mortgages. Although most of these people pay a fixed amount each month, some have payments that change with interest rates. Increases in interest rates increase the amount people with variable payments spend on their mortgage each month. This reduces the amount of money they have for optional, or discretionary, spending. For instance, they might choose to eat in instead of dining at a restaurant, or watch a movie at home rather than at a cinema.
While higher rates reduce spending on optional purchases like luxury goods or travel, they have less of an effect on purchases of day-to-day necessities. Demand for groceries doesn’t change much when households have less money in their pockets because people need to eat. The same is true for other important services like internet and mobile service. So, a higher policy interest rate takes longer to slow the growth in prices for essential goods and services.
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