The Bank of Canada is a crown corporation and Canada's central bank. It was chartered in 1934 under the Bank of Canada act and is responsible for formulating Canada's monetary policy and regulating Canada's financial systems. Its principal role is "to promote the economic and financial welfare of Canada". Led by a governing council, its main tool for conducting monetary policy is the target for the overnight rate, or the key policy rate. By changing this rate, it can influence the supply of money circulating within Canada's economy. It is also solely responsible for the issuance and distribution of Canadian currency and regulation of foreign currency reserves.
The Bank of Canada held its 2nd meeting of the year on March 10th, 2021. Highlights from the meeting include:
Their rate decision aligns with our forecast for the Bank of Canada rate. Our models continue to show that the Bank of Canada target overnight rate is likely to remain at 0.25%, or the lower bound, until 2023. However, given the rapid rise of housing prices in Canada as well as a forecast for a strong economic recovery, it is likely that they will allow longer-term rates to rise and finish their QE program.
|Date||Target Overnight Rate||Change|
|December 8th||To Be Decided||--|
|October 27th||To Be Decided||--|
|September 8th||To Be Decided||--|
|July 14th||To Be Decided||--|
|June 9th||To Be Decided||--|
|April 21st||To Be Decided||--|
|Date||Target Overnight Rate||Change|
The Bank of Canada makes its decisions based on the growth of the Consumer Price Index (CPI) from Statistics Canada. This is calculated from the price of a monthly “basket” of goods and services typically used by Canadians. It represents a broad picture of consumer spending across Canada.
Using its monetary policy tools, the Bank of Canada aims to maintain inflation, as calculated by changes in the CPI, within a certain range. Introduced in 1991, the inflation-control target sets a range of 1% – 3% as the ideal range for annual inflation, with the midpoint of 2% being the common target rate. This range is reviewed regularly with the latest review being in October 2016.
The Bank of Canada reviews its benchmark interest rate eight times a year and considers both local and international, current and potential influences in their review. Although the Bank of Canada operates independently of the government, it is ultimately responsible to Parliament through the Minister of Finance.
Think of the banks as a group of friends. The banks don't like to hold cash and like to lend out their money whenever they can. Sometimes, Bank A might have a lot of cash on its hands while Bank B might have less. Since they're friends, Bank A is more than happy to lend money to Bank B. But they're banks, so they don't want to lend their money out for free. So they charge an interest rate.
Everyday, the banks come together and make offers to borrow and lend money. The rate that they settle on is called the "overnight rate" because it's the interest rate for borrowing cash "overnight". The Bank of Canada is the "mom" of the group. The Bank of Canada has a "target overnight rate" and tries to keep the overnight rate close to the target. If the rate gets too low because there's too much money, the banks can lend their money to the Bank of Canada instead. If the rate gets too high because there's a shortage of money, the Bank of Canada acts as a "lender of last resort" and will lend out money.
|Date||Target Overnight Rate||Change|
|March 27th, 2020||0.25%||-0.5|
|March 16th, 2020||0.75%||-0.5|
|March 4th, 2020||1.25%||-0.5|
|October 24th, 2018||1.75%||0.25|
|July 11th, 2018||1.5%||0.25|
|January 17th, 2018||1.25%||0.25|
|September 6th, 2017||1%||0.25|
|July 12th, 2017||0.75%||0.25|
|July 15th, 2015||0.5%||-0.25|
|January 21st, 2015||0.75%||-0.25|
|September 8th, 2010||1%||0.25|
|July 20th, 2010||0.75%||0.25|
Recent events have pushed the Bank of Canada to rapidly drop their Target Overnight Rate to 0.25% in early 2020. We expect the BoC to maintain their current target overnight rate of 0.25% for the remainder of 2020.
Our rationale is based on the impacts of COVID-19 on the economy and the Consumer Price Index (CPI) as well as announcements by the Bank of Canada. Statistics Canada reported that Canada's GDP dropped by a record-breaking 11.6% in April following a 7.5% decline in March. Despite a rebound in commodity prices and the easing of COVID-19 lockdowns, a July report by the BoC expects a slow recovery with demand remaining weak relative to supply. Their central case projections estimate that it will take until at least 2023 before Canada's GDP recovers to previous highs. In addition, the CPI remains near 0%, significantly below the BoC's target of 2%, giving the BoC room to continue loose monetary policy and quantitative easing. The BoC confirmed these projections at their October policy meeting when they announced that they do not expect to increase their target overnight rate until at least 2023.
With central bank projections of a U-shaped recovery extending to 2023 and beyond, we expect the Bank of Canada's target overnight rate to remain at the lower bound of 0.25% in 2021.
At their October policy meeting, the BoC announced that they do not expect to raise their target overnight rate until at least 2023. This follows their July report projecting a slow U-shaped economic recovery that will not return to previous highs before 2022. Other central banks have followed with similar projections. In their June meeting, the Federal Open Market Committee of the US Federal Reserve predicted that the US economy would take until 2022 to return to previous highs. These economic projections are also held by the European Central Bank (ECB) with economic recovery predicted to take until late 2022. With economically indicators showing a delayed recovery in developed markets all over the world, the BoC is unlikely to raise rates and risk dampening the recovery further.
The zero lower bound is no longer the strict rule that it once was - the European Central Bank (ECB), the Bank of Japan (BOJ), and central banks of Denmark, Sweden, and Switzerland have all experimented with breaking the zero barrier. The ECB and BOJ have both used negative deposit rates since 2014 and 2016 respectively, and the BOJ has had decades of experience with near-zero rates. Why doesn't the Bank of Canada do the same with negative rates?
Negative rates have significant implications for the financial sector as banks can't offload the costs of the negative rate onto their clients (imagine how popular a negative-rate savings account would be). According to a BoC paper from 2015, this can significantly compress margins for banks and other financial institutions as well as create market distortions. Due to these reasons and other effects of a negative interest rate policy, the Governor of the Bank of Canada, Tiff Macklem, has announced that he does not see negative interest rates as a viable option for the BoC.
Above, we have predicted that the Bank of Canada's Target Overnight Rate will remain at 0.25% for 2021 and remain unchanged in 2022. From 2023 onwards, the outlook is less certain and highly dependent on how the Canadian and global economy recovers after COVID-19. In their October 28th Canada Monetary Policy Report, the Bank of Canada projected CPI inflation would remain below their target of 2.0% until beyond 2022. With lower growth expectations for the next few years, it is unlikely that they will sustainably reach their target by 2025. The US Federal Reserve has also moved to an average inflation targeting mechanism that will keep interest rates low even with short periods of higher inflation. With pressure from low growth and its southern neighbour, the BoC is likely to keep rates at their effective lower bound of 0.25% until 2023 before rising to a maximum of 1.75% by 2025.
The massive amounts of debt raised by both federal and provincial Canadian governments will pose a barrier to any further increases in interest rates. The Federal government alone is expected to borrow $713 billion CAD in 2020, more than double the amount raised in 2019. While Canada's debt-to-GDP ratio of 49% in 2020 still remains low relative to other OECD nations, the additional pressure of interest payments amidst a struggling economy and depressed commodity prices will stall any hawkish measures to raise interest rates by the Bank of Canada.
Through the key policy rate and its other monetary policy tools, the Bank of Canada influences the interest rate for all borrowing and lending transactions in Canada. For example, changes in the key policy rate usually lead to changes in bank Prime rates. Subsequently, the key policy rate has significant influence on variable mortgage rates that are based on a lender's Prime rate.
Changes in the key policy rate and monetary policy can also affect fixed mortgage rates. Fixed mortgage rates usually follow the yields of Government of Canada 5-Year bonds. A shift in monetary policy can lead to changes in the bond yields, which will then lead to changes in fixed mortgage rates.
We expect variable mortgage rates to remain stable until at least 2022. Variable mortgage rates are based on the Prime rate, which follows to the Bank of Canada target overnight rate. Our projections show that the BoC is unlikely to deviate from its current overnight rate of 0.25%. Consequently, Prime rates and variable mortgage rates are likely to also remain stable.
Increased competition in the mortgage sector may lead to discounts for new mortgages or refinances, but variable mortgage rates are already near historical lows and it is unlikely that rates will go down further.
We expect fixed mortgage rates to remain around current levels until 2022. We do not expect rates to return to pre-COVID-19 highs by 2025. Fixed mortgage rates are highly linked to Government of Canada bond yields, which have been suppressed by the BoC's bond purchase program of more than $5 billion CAD every week. Pledging to continue quantitative easing until inflation returns to its 2% target, it is unlikely that bond yields will rise in the near future and lead to higher fixed mortgage rates.
The Bank of Canada was created as part of the Bank of Canada Act in 1935. It was recommended by the Royal Commission in response to the economic conditions of the Great Depression. In March 1935, the Bank of Canada was opened to the public as a private institution with shares sold to public investors. It was quickly nationalized as a public institution by an amendment to the Bank of Canada Act in 1938.
The Bank of Canada rate (not officially the target overnight rate until much later in the century) started at 2.5% in 1935 and ended at 1.5% in 1945. The economy strengthened during the war as Canada played a vital role in supplying natural and manufactured resources to the Allies. There was also increased employment, especially of women. The decrease in the Bank of Canada rate encouraged people and businesses to borrow money to invest in new manufacturing plants and housing.
After World War II, the Bank of Canada rate did not rise until October 1955, when it was changed to 2.0%. This low-interest rate environment promoted investment in new infrastructure, manufacturing, housing and consumer goods.
After the upward change in 1955, the Bank of Canada rate continued to rise slowly throughout the 1960s and early 1970s. In October 1978, the benchmark rate hit double digits for the first time at 10.25%. This was due in part to the global oil crisis and the OPEC oil embargo. With record-high prices for oil in August 1980 that continued into 1981, the Bank of Canada rate hit an all-time high of 20.03% in August 1981. The lowest rate reached during this period was 7.14% (March 1987).
After the recession of the 1980s, the Bank of Canada rate between 1991 – 2009 generally went downwards with only a few exceptions. The inflation-target rate was introduced at the beginning of this period.
In March 2009, the BOC rate dipped below 1% for the first time to 0.5% in response to the Great Financial Crisis. Despite a minor recovery, in 2014, oil prices dropped a staggering 60%, causing a recession in Canada's oil-driven export economy. The Bank of Canada rate then dropped from 1.25% to 0.75% in 2015.
Despite widespread economic growth, 2018 and 2019 were marked by continued low inflation, preventing the Bank of Canada from raising rates any higher than 1.75%. This was quickly reversed with the impact of COVID-19 with a two 50 basis point drops in March 2020. The Bank of Canada rate now lies near its lower limit at 0.25% and is unlikely to be raised anytime soon due to the deflationary impact of reduced consumer spending and distressed economy.