How is the Bank of Canada interest rate set

#MakeItMakeSense is a series from the Star that breaks down personal finance questions to help young Canadians gain more confidence and understanding around financial literacy

When you think of interest, you may think of the charges you got after you didn’t pay off your credit card balance in full at the end of the month. Or, perhaps you think of the interest on one of your investments that has helped you gain money over time.

In essence, interest is a major part of many of our daily finances but for those who are trying to better understand how interest works when it comes to the Bank of Canada and what impacts the percentages it sets, the information can be hard to find and even more difficult to digest.

Luckily, we brought in money expert Jessica Moorhouse to help those looking to better understand interest as a whole for this week’s #MakeItMakeSense.

What is interest and how does it work?

Interest can be good or bad: It can be the cost of borrowing — or the reward for saving.

For example, if you have an outstanding balance on your student loan, interest accumulates on the amount owing.

On the other hand, interest also works as a reward for saving because you can earn that interest rate, instead of being charged for it.

For example, if you put money into a savings account that pays a 1.5 per cent interest rate, you’ll earn money over time.

For businesses, while Moorhouse said they do operate with cash in the bank, they typically also lean heavily on credit to pay things like bills, payroll and inventory on time while they wait for invoices to be paid or product to be sold.

“Because they depend on credit for keeping things running, when interest rates rise, that becomes an added cost to businesses,” Moorhouse said.

“(A rise in interest rates) can have a negative impact on the profits of businesses that need to borrow which, in turn, may cause their share prices to fall,” she said.

In order to pay this added cost, they’ll often raise prices or do “shrinkflation,” Moorhouse notes, which means they’ll keep the price for an item the same but reduce the size of the product. In other words, they’ll pass on the cost to the customer.

What is a key interest rate and how does it impact financial institutions?

You may have heard “key interest rate” among many other terms floating around in the latest finance news, including “policy interest rate,” “overnight rate,” and “target rate.” But what’s the difference?

According to Moorhouse, there is none and these terms all mean the same thing.

Key interest rates and the Bank of Canada have been at the top of the news following last month’s announcement that the bank’s key interest rate was raised to 2.5 per cent. The bank announces whether or not they will change the key interest rate on eight preset dates a year.

While some people mistakenly think the Bank of Canada is operated by the government, it is actually a crown corporation, which is owned by the government, but operates independently, Moorhouse explained.

“(This means) it’s tied to the government but they are completely separate entities. The government cannot tell the Bank of Canada what to do, like that will just not work,” she said.

Every business day, Canada’s financial institutions move money back and forth among themselves for their customers, Moorhouse said.

“Whenever you (a banking customer) use your debit card or send an e-transfer, money flows between financial institutions. At the end of each day, they need to settle all these payments,” she said.

Moorhouse adds some institutions may have sent out more in payments than they received, while others may have received more than they sent.

“To balance out the payments, financial institutions can borrow money from each other for one day in the overnight market — these loans are called overnight loans,” she said.

“The Bank of Canada sets a target for the interest rate we want financial institutions to charge each other when they make these overnight loans,” said Moorhouse.

These financial institutions don’t have to borrow from each other to balance their payments as they can also use the Bank of Canada, adds Moorhouse.

“They can deposit money with the Bank of Canada at the deposit rate for one night or borrow money from us at the bank rate for one night,” she said.

All this activity determines the overnight rate, which is the interest rate at which financial institutions can borrow from each other. And ultimately sets the current key interest rate.

Why do interest rates increase and decrease?

“If interest rates go up, it makes it more expensive for these banks to borrow from one another … So they’re going to pass that cost on to their customers … by raising their overnight rate … Basically, it makes it way more expensive for customers to borrow. It makes it more expensive if they already have a loan or if they want to get a loan,” said Moorhouse.

When interest rates rise, the hope is that people will save more, as they could potentially earn more in interest than previous years.

“The whole intention of the Bank of Canada raising the key interest rate — and there’s a lot of different reasons — but for what they’re currently doing now, it’s really because they want to lower inflation because inflation is quite high,” Moorhouse said .

“And the reason inflation is high is because there’s a lot of demand and hardly any supply and a bunch of other reasons,” she said.

So, in order to motivate people to stop borrowing money to buy things, they raise the interest rate, said Moorhouse.

If it gets more expensive to borrow, people may think twice, said Moorhouse. “’Oh gosh, it’s so expensive to borrow money. Maybe I’m not going to spend money right now. Maybe actually I’ll shift my focus to saving and delay my purchases.’”

“If people spend less, delay those purchases … then there’s going to be less of a demand, there’s going to be more of an equilibrium eventually and then inflation will go down.”

As for when rates decrease, Moorhouse points to an example of if the bank lowers the key interest rate from 1.75 per cent to 1.5 per cent, its goal is to make it cheaper for consumers and businesses to borrow in order to encourage them to borrow money and increase spending in the economy.

“If they’re lowering it they want you to spend, if they’re raising it they want you to spend less and save more,” she said.

Got a question or scenario that you’d like to see tackled? Reach out to Madi via email [email protected] and we’ll #MakeItMakeSense.

Jessica Moorhouse is an Accredited Financial Counselor Canada®, host of the More Money Podcast and founder of financial education company MoorMoney Media Inc.

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