The Bank of Canada Holds Interest Rates at 1%, Worries About Low Inflation

The Bank of Canada’s interest rate announcement last month was largely overshadowed by the shooting in Ottawa. This past week Bank of Canada Governor Stephen Poloz held his first news conference since the interest rate announcement on October 22nd. Under normal circumstances, the news conferences would have taken place on the same day as the interest rate announcement, but with security concerns top of mind, it was postponed. Let’s recap the announcement, as well as discuss our central bank’s fear of low inflation, and the impact it has for consumers.

Bank of Canada Holding Interest Rates at 1%

It should come as no surprise the Bank of Canada once again held interest rates at 1 per cent last month. The overnight lending rate has been frozen at 1 per cent since September 2010. While there was nothing earthshattering about the announcement, a change in language raised many eyebrows.

Conspicuous by its absence was the Bank of Canada’s neutral stand on monetary policy. What’s neutral monetary policy? It’s best described as the equilibrium of the Canadian economy. It’s a rate that neither accelerates or slows down economic growth.

The Bank of Canada’s statement normally has the following phrase on how the bank “remains neutral with respect to the next change to the policy rate; its timing and direction will depend on how new information influences the outlook and assessment of risks.” Instead, it’s nowhere to be found, although the following phrase remains: “the balance of risks falls within the zone for which the current stance of monetary policy is appropriate.”

What is the Overnight Lending Rate?

The overnight lending rate is often referred to by the Bank of Canada as the key interest rate or key policy rate. This rate is important because it’s the rate the Bank of Canada uses to carry out monetary policy. The overnight lending rate is the rate financial institutions use to borrow and lend one-day funds between each other.

The Bank of Canada has a set schedule of eight announcements of interest rates per calendar year. The overnight lending rate is influenced by several factors including economic growth, inflation, exports, consumer debt, and more.

Why Interest Rates Matter

A change in the overnight lending rate would have a trickle-down effect felt throughout the Canadian economy. Although financial institutions set their own prime rate, it’s based on the overnight lending rate, plus a spread. For example, prime rate at most financial institutions today is 3 per cent (the overnight lending rate plus a 2 per cent spread).

If prime rate were to increase, the cost of borrowing for debt tied to prime rate would also increase. Debt tied to prime rate includes variable rate mortgages, lines of credit, personal loans, car loans, RRSP loans, floating rate student loans, and some credit cards.

The Bank of Canada Worries About Low Inflation

Despite Canada’s inflation rate hitting the 2 per cent target in September, the Bank of Canada remains worried about low inflation. With our central bank worrying out loud about inflation rates, it pushes back fears of a hike in the overnight lending rate until at least mid-2015.

While low inflation may seem like good news for consumers, a healthy level of inflation is important. When prices remain low, consumers and businesses stop spending. Such delays in spending hurt economic growth and can lead to a recession. Low inflation leads lower profits for corporations and lower wage increases for employees. Low inflation makes paying off consumer debt challenging. It’s difficult to pay off your mortgage when your annual salary increase at work is negligible. Low inflation can even lead to deflation, as experienced in countries like Japan, where prices fall.

The Bottom Line

With the Canadian economy still not back to full capacity, it shouldn’t come as any surprise the Bank of Canada held the overnight lending rate steady at 1 per cent. It’s unlikely our central bank will raise interest rates before the U.S. Federal Reserve. With interest rates not expected to rise until mid-2015, it be will interesting to see whether if the Bank of Canada follows through or once again pushes back hiking rates.