One of the primary responsibilities of the Bank of Canada is to determine the country’s interest rate policy. Naturally, the topic of interest rates always fuels considerable debate and with the economy still under-performing despite rates being close to an all-time low, some analysts suggest the Bank of Canada may have little choice but to consider implementing a negative interest rate. In this Home Trust Mortgages Blog entry, we’ll look at how the Bank of Canada influences retail interest rates and some of the possible outcomes should the Bank of Canada adopt this controversial interest rate strategy.
The Bank of Canada Overnight Lending Rate
When the economy is expanding to the point of inflation, the Bank of Canada can increase interest rates making it more expensive for consumers to borrow. This tends to reduce overall spending and slow growth to a more manageable rate. The opposite holds true when the economy is weakening; in this case, the Bank of Canada will reduce rates in an attempt to encourage borrowing and boost consumer spending.
The primary mechanism the Bank of Canada has to manage interest rates is through the Overnight Lending Rate. This is the interest rate the retail banks earn on the funds they hold on overnight deposit with the Bank of Canada.
By manipulating the Overnight Lending Rate, the Bank of Canada can influence retail interest rates. When the Overnight Lending Rate increases, the banks will typically increase deposits; when the Bank of Canada lowers the rate, the banks will reduce deposits and make more funds available for lending. The banks will often introduce lower lending rates and special deals to attract more business and it is this relationship between the Overnight Lending Rates and the retail and commercial lending rates that enables the Bank of Canada to manage the country’s interest rate policy.
Some economists have proposed that the Bank of Canada would have to slash the current rate of just 0.5% well into negative territory in order to have a meaningful impact. Should this happen, the banks, in exchange for keeping their funds with the Bank of Canada, would then be required to pay interest on their deposits. To avoid this reality, it is very likely that the banks would drastically reduce their deposits thereby making more money available for lending to their customers.
Negative Interest Rates and the Housing Market
Let’s make one thing clear– the introduction of a negative Overnight Lending Rate by the Bank of Canada will not result in your financial institution paying you to take out a loan. Lenders may well lower their rates if the Bank of Canada slashes the Overnight Lending Rate, but don’t expect to borrow for free.
Ultimately, whether or not the Bank of Canada takes the unprecedented action of implementing a negative interest rate, there are very few market watchers who expect that interest rates are going to increase appreciably any time soon. For those looking to borrow for a new home or other large purchase, it appears that rates will remain near the current levels for some time.
Continued low interest rates should help boost, or at least maintain, activity in most real estate markets. There are exceptions, of course; markets in those areas directly impacted by weak energy prices may not share this outlook, but in many other parts of the country including hot spots like Toronto, the prospect of low interest rates should help to support these very active markets.
Despite the warnings that properties in these two cities in particular are over-valued, so long as demand continues to outstrip supply, and interest rates remain at or near the current historical lows, it seems likely home sales will continue to expand.
This post is intended for informational purposes only and is not to be considered financial advice.