The Outlook of Canadian Interest Rate
Economists have been asking the same questions for centuries: how do we develop production, increase demand, increase productivity, and maintain inflation. The answers for those questions change over time. That’s why the economy is labelled as a social science study. Since the financial bubble burst in 2008, economists have not received enough sleep. They have needed to make new policies to go with the new economic situation around the world. Through Canadian eyes, we are comparing our monetary policy with Canada’s big brother and predicting what will happen in the future.
Some background
The Bank of Canada sets the overnight rate target to perform as its monetary policy instrument. Since the financial crisis in 2008, the Bank has lowered its overnight rate target from 2.25% to 1.5%. Since then, the Bank has changed the interest rate target ranging from 0.25% to 1%. Due to low oil and commodity prices over the past two years, the Bank decided once again to lower the target rate to 0.5% in July 2015. The last interest rate announcement stated that the bank will maintain the overnight rate target at ½ percent. The next announcement is scheduled for September 7, 2016.
Operating band of interest rate
The overnight rate target is also called the key policy rate (the middle in the operating band). It’s the rate at which banks and other financial institutions can borrow money for a period of overnight. Higher 25 basis points from the overnight rate is called the bank rate, which is the rate at which the Bank lends money to domestic banks. In addition, the lowest interest rate on the operating band, which is lower 25 basis points from the overnight rate, is called the deposit rate. It is the interest rate paid on deposits at financial institutions. Overall, the bank rate and the deposit rate move 25 basis points up and down from the overnight rate target (which makes for a 50 basis point operating band).
When the Bank changes the target rate, it leads to a change in the exchange rate of the Canadian dollar, domestic asset prices and market interest rates. The monetary policy actions take time, and normally the effects cannot be seen until after 1.5 to 2 years.
Comparing to the Federal Reserve (FED)
The Fed has sharply decreased the overnight rate target from 4.5% in 2008 to 0.25%. They have maintained the interest rate at nearly zero and had not increased the 2006 rate for nearly a decade. In December 2015, the Fed finally increased the key policy rate by 25 basis point to 0.5%.
The historical move was supported with a moderate pace of economic expansion since the Great Depression. The unemployment level showed a good result which has fallen to 5% (close to the natural unemployment rate of 5.5%). Inflation, however, has not met the Fed’s 2% inflation target with just 1.3%. The next announcement on interest rate target is scheduled for September 16 2016
Forecasting
The Canadian interest rate is expected to stay the same or even decrease at the end of 2016. Weaker business investment, especially in the energy sector, soft global demand in particular for Canadian exports, a slowdown in Chinese oil demand, and uncertainty because of the UK referendum are some of the reasons why some analysts think that the Bank will lower the interest rate again in the future.
In the July monetary policy report, the Bank is confident about the future: non-commodity exports would support economic growth, increases in household spending and inflation that are close to the 2% 2017 target. If Canada’s economic recovery is going as expected and there are no further disruptions, then the Bank is most likely to keep the interest rate at the current level. Inflation target is the goal of the Bank of Canada. There is still a gap between the real inflation rate and their target at 2%. Now the inflation rate is 1.3% as Canadians are paying more for food and shelter but less for gasoline.
Let’s now consider if there is a major turmoil in the market that hits the economy really hard (or unemployment rate increases and inflation is low) and the Bank decides to lower the interest rate to 0.25%. Lowering the interest rate is going to be at the risk for further inflating housing prices, especially in Toronto and Vancouver, and also depreciating our dollar against the US dollar. Low interest rate impacts can be seen widely when the depository institutions lower its deposit rate. Depositors receive lower interest rate on the money that they deposit in a bank. Canadian stock prices would also sink under US stocks because holding US stocks is more valuable. The upside of having a low interest rate is that loans and mortgages are cheaper as a mean of encouraging people to spend their money, although it means that they need to cut their saving.
On the contrary, indebted households have little power to cope with losses in income and rising interest rates. With increasing the overnight target we are unlikely to be looking at the inflation rate still below the target rate.
Furthermore, the Canadian dollar is known as a petro-currency. However, the current data shows that there might be a divorce between this correlation. This is a good thing since investors will look up at the Canadian economy not judging based solely on oil prices but also other economic sectors.
Aside from Canada’s monetary policy, we need to see how Canada’s big brother is doing. The US economy is showing a decent growth with the unemployment rate at 4.9% and claims for unemployment insurance have fallen below pre-crisis lows. However, it faces some challenges because of the decrease in business investment and weaker global demand. After all, US domestic demand remains solid and global growth has improved.
The Fed is widely expected to increase the interest rate at the end of this year. But the last Federal Reserve meeting showed a mixed feelings between the policy makers. Some believed that another increase is appropriate looking at the economic conditions. Other argued that more data is needed.
What it means for Canadians if US raise interest rate?
If the Fed raises the interest rate again, then we can expect that the US dollar will grow even stronger than today and of course our currency would depreciate. People are more interested in buying US investments that offer a higher return. Before they buy US investments, people need to sell their own currency and buy US currency which will push up even further appreciation of the US dollar.
It’s bad news for Canadians who want to travel abroad but it’s good news to for our exports since we expect they will increase.
