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 7th meeting of the year on October 27th, 2021. Highlights from the meeting include:
CPI inflation rose above what the Bank of Canada was expecting and will remain elevated for the rest of the year. While there's no rate hike this month, the ending of the bank's QE program does signal a change in pace as the possibility of several rate hikes in 2022 increase, especially since inflation is expected to be higher for longer.
|Date||Target Overnight Rate||Change|
|December 8th||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|
|June 1st, 2010||0.5%||0.25|
|July 20th, 2010||0.75%||0.25|
|September 8th, 2010||1%||0.25|
|January 21st, 2015||0.75%||-0.25|
|July 15th, 2015||0.5%||-0.25|
|July 12th, 2017||0.75%||0.25|
|September 6th, 2017||1%||0.25|
|January 17th, 2018||1.25%||0.25|
|July 11th, 2018||1.5%||0.25|
|October 24th, 2018||1.75%||0.25|
|March 4th, 2020||1.25%||-0.5|
|March 16th, 2020||0.75%||-0.5|
|March 27th, 2020||0.25%||-0.5|
Despite rising asset and commodity prices, the Bank of Canada has signalled that their Target Overnight Rate will remain stable at 0.25% for 2021. We expect to BoC to maintain their commitment and do not expect any rate changes by the end of 2021.
Our rationale is based on the uncertainty of recovery from COVID-19 as well as the policy and political motivations of the Bank of Canada. While Canada's economy showed a higher-than-expected rebound in Q1 2021, new lockdowns and the high likelihood of the spread of new variants have put a pause on further growth. Slow vaccine rollout campaigns are also likely to prevent a full recovery by the start of Q4 2021. We expect these factors will push the Bank of Canada to maintain a loose monetary policy in order to continue to support Canada's recovery from COVID-19.
From a policy and political side, the new Federal 2021 budget expects a budget deficit of $154.7 billion CAD for the next year and elevated deficits for the years after. The Bank of Canada already owns more than 40% of total federal government debt and we expect them to continue to help to monetize federal debt as well as assist in Canada's economic growth.
Due to rising asset and commodity prices as well as expectations for a better-than-expected economic growth in 2021 and 2022, we expect the Bank of Canada's target overnight rate to rise to 0.5% by the end of 2022.
Record-breaking activity in Canada's housing markets and rising commodity prices are likely to put upward pressure on CPI measures in 2022. CPI is already expected to exceed 2% in 2021, and we expect that the Bank of Canada will find that the rise in the rate of inflation is not temporary. Consequently, we predict that the BoC will raise their target overnight rate to a minimum of 0.50% by the end of 2022.
At this point in time, we do not expect the target overnight rate to exceed 0.75% in 2022. The US Federal Reserve has signalled that it will maintain its overnight rate at the zero bound until 2023, putting pressure on the BoC to maintain a similar stance. At the same time, both the Federal Reserve and the Bank of Canada have other tools to tighten monetary policy including the reduction of their QE programs. We expect the BoC to slowly reduce its debt purchase program before it takes further actions to raise its policy interest rate.
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 rise to 0.50% in 2022. From 2023 onwards, the outlook is less certain and highly dependent on global macroeconomic factors. CPI inflation is expected to surpass the BoC's target of 2% in 2021 and stabilize at 2% in 2022 and beyond. However, it is likely that increased global liquidity and fiscal spending will continue to put upward pressure on prices and drive inflation upwards. Conventionally, this would prompt the BoC to continue to raise rates.
However, 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. The 2021 Federal Budget shows a commitment to further deficit spending with a deficit of $154.7 billion this year. While much of Canada's debt is already owned by the Bank of Canada, it would be counter-productive to the aims of Canada's government to increase rates and tighten monetary policy while the government is deficit-spending to boost the economy.
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 2021 with a rate hike in the second half of 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.
As of April 2021, fixed mortgage rates are already rising to take into account higher inflation expectations and 5-year bond yields. We expect them to remain at current levels until the second-half of 2021 before rising further to match rising inflation expectations.
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.