Canada’s central bank wants you to know rising rates suck, but ultimately it will make life more affordable. This week the Bank of Canada (BoC) posted a Twitter thread on why higher interest rates will make life more affordable. They explained the influence on goods but assumed the reader would have some base knowledge on how rates work. Since some people might not have that base knowledge, we thought we’d break down how higher rates will ultimately improve the cost of living.
The Central Bank’s Primary Mandate Is To Control Inflation
The primary role of the central bank is to control inflation, which ultimately means the value of money. They try to do this by keeping it at a level they feel is low enough to not excessively erode money, but high enough to prevent “hoarding.” It’s a balance between not seeing the value of your labor erode, but also having it erode at a rate you’ll keep spending and investing. The current target rate of inflation is 2%, with a tolerance of one-point higher or lower.
The Primary Tool Used To Control Inflation Is Interest Rates
The primary tool they use to execute this task are interest rates. In Canada, the overnight rate is a particularly important one, influencing the cost of most short-term credit. If inflation is too low, they slash rates to make debt cheap, incentivizing borrowing. Usually if you’re borrowing, you’re buying something. Afterall, how can you not splurge on that house when the cost of borrowing is this low? You might have been planning to buy something later, but the cheap debt means this is the ideal time.
By stimulating demand, the central bank is increasing competition for goods, and the price of those goods. To put it bluntly, the goal is to stimulate demand in excess of supply to create a shortage of goods, boosting inflation. This whole concept works since credit can be made faster than supply chains can respond to the increase in demand.
Higher Interest Rates Will Slow Inflation And Improve Affordability
All good parties come to an end though. Sometimes the stimulated demand, which is not natural, becomes excessive. In this situation the opposite happens — interest rates rise and the cost of borrowing does as well. This reduces incentive to borrow, reducing the artificial demand and lowering competition for goods and services. Less demand reduces the strain on supply, so prices stop rising. In some cases prices may fall if the future expectation of price growth was also funding supply.
Ultimately the BoC is making the decision to control inflation over the cost of financing since it’s healthier for the economy. National Bank of Canada (BoC) estimates if the policy rate rises to 3.25%, the impact would be about 1% of disposable income lost. In contrast, the current rate of inflation means 8 points are being lost per year.
The BoC asserts it will control inflation, which is a huge change from earlier this year when they claimed it was outside of their ability to control. It comes after Canadian Parliament summoned us to a committee to explain how the BoC was creating inflation, but hey — better late than never?