Why Is BoC Increasing Interest Rate? –Top Five Reasons
The central bank increases or decreases the interest rates prevailing in the economy to stabilize it. Below is a list of the five major factors that are forcing the BoC to hike the interest rates:
Undoubtedly, inflation is soaring high in Canada. In January 2022, it increased to a 30-year high primarily on account of:
- Increase in food prices
- Increase in energy charges
- Disruptions in the global supply chains and
- A rise in the prices of automobiles
It has forced the Bank of Canada to hike interest rates to control the rising inflation. In effect, this will:
- Cause the cost of borrowing to rise, and it will be comparatively expensive for the people to borrow money.
- Reduce the supply of money in the economy. The people will have less money to spend on goods and services will help stabilize the demand side.
A rise in interest rate will deter people from borrowing money and even spending it on buying goods and services. With the supply side remaining constant, this will lead to a fall in demand, and the prices will fall.
2. Tightening Labour Market
The present economy of Canada is close to full employment, and recruiters are finding it tough to hire employees. The pool of workers has shrunk to a bare minimum, and Canada is experiencing the worst situation of labour tightening.
Such a shortage has upward pressured and even augmented the workers’ bargaining power. It plays a prominent role in enhancing the general price level of goods and services because:
- The economy does not have the luxury of hiring additional workers and cannot meet the ever-increasing demand for goods and services.
- Wage hikes contribute to the closing price of goods and services, making them costlier.
A tightened labour market is one of the main reasons for a rising inflation rate. Thus, BoC has opted to increase the interest rate to cool off inflation and regulate the general price level of goods and services.
3. Booming Housing Market
The housing market in Canada is simply bustling and booming like never. The average home prices are rising by a whopping 30% YoY. Compared with the pre-pandemic levels, there has been a 50% increase in February 2022.
Below are some common factors that handle such an unprecedented price hike:
- Low Mortgage Rates are prompting several new as well as existing homebuyers to invest in the housing sector
- Robust demand for residential houses coupled with a shortage of house properties
- The resumption of immigration of skilled labour
- A shift in the preferences of homebuyer’s post-pandemic
- An increase in the household savings
These factors have made the housing sector quite lucrative, causing the investors to borrow heavily from the banks. The rise in prices of residential houses has also contributed to inflation, which the BoC wants to control by hiking the interest rates.
4. Russia-Ukraine War
The ongoing conflict between Russia and Ukraine has hurt the entire world, including Canada. Besides human suffering, bombings, and planned destruction of humanity, it has even played a key role in causing inflation in the world.
Russia is a top supplier of Gas and Oil and has always been in a cold war with the NATO countries. Canada is one of the twelve founding countries of NATO. Hence, indirectly, it is also fighting against the Russian ideology.
Because of the invasion, the prices of several commodities, including oil and Natural Gas, have increased. Additionally, a disruption in the global supply chains impacted the supply side adversely.
Thus, the Russia-Ukraine conflict has put stress on the Canadian economy. It has forced BoC to interfere and normalize the prices via interest rate hikes.
5. Moderation of Domestic Demand
The current economy of Canada is robust and is growing strongly. The central bank of Canada expects the Canadian economy to grow by 4.25% this fiscal year. There has been a rising trend in Foreign direct investments, productivity, immigration, and consumer spending.
All these factors have together enhanced the overall productivity of the Canadian economy. Even the export business houses, and manufacturers have recovered well and will continue to do so on the back of strong foreign demand.
Thus, BoC, in a bid to moderate the strong domestic demand and exceptionally elevated level of activities in the housing market, wants to tone down it by raising the interest rates.
What Happens When Interest Rates Increase?
While a rise in the interest rates acts as a boon for the savers, it hurts the borrowers.
When the central bank of a country increases the interest rates:
- The mortgage rates become expensive, and the borrowers prefer not to invest in the housing sector.
- The lenders charge higher for automobile loans discouraging people own an automobile.
- Cost of business finances increases. It requires them to spend more on the interest cost shrinking their profit margins.
- Consumers tend to spend less in the economy. It leads to a fall in demand for goods and services.
- The overall circulation of money in the economy decreases as there is a weak demand for loans.
- There is an increase in the deposit growth rate due to an increased level of savings.
- People prefer to keep their money in banks and financial institutions as they get a handsome return on their savings/ investments.