Central Bank Surprises Markets, Raises Key Lending Rate
The Bank of Canada raised its key lending rate on September 5 to one percent, up from a rate hike to 0.75% in July. The two rate hikes in 2017 erase the two rate cuts that came in 2015 in response to plunging oil prices.1
“Recent economic data have been stronger than expected, supporting the Bank’s view that growth in Canada is becoming more broadly-based and self-sustaining,” the central bank noted in a statement.
The central bank rate hike comes after Statistics Canada revealed the Canadian economy advanced at an annualized rate of 4.5% in the second quarter. Economists had forecast gross domestic product (GDP) growth of 3.7%. By comparison, the U.S. economy advanced 3.0% in the second quarter.2
Where the U.S. dollar has been the worst performing currency in the G10 in 2017, the Loonie is one of the best performers. The rate hike helped send the Canadian dollar significantly higher against the U.S. dollar.
The rate hike helped drive the Loonie close to two percent higher in the first week of September. The Loonie is now trading at US$0.82; the highest levels since May 2015. In 2017 alone, the Canadian dollar has advanced nearly 10% against the greenback.
Is a higher interest rate and dollar good for Canadians?
When the economy is doing poorly, the Bank of Canada lowers interest rates in an effort to juice economic activity by making it cheaper to borrow money. When the economy is doing better, the central bank raises rates to keep growth and inflation in check.
When the Bank of Canada raised its rates in July from 0.5% to 0.75%, all of Canada’s big banks passed that full increase onto consumers and businesses by raising their prime lending rates by a quarter of a percentage point; to 2.95% from 2.7%. Interestingly, when the Bank of Canada cut rates twice in 2015, the country’s big banks did not pass on the full discount to consumers.
Prime rates impact financial products like variable-rate mortgages and home equity lines of credit. Raising rates means Canadian consumers and businesses bear the full-brunt of the rate hike. That will negatively impact consumer spending and borrowing costs. It will also hurt Canadian companies that rely on export sales.
The central bank is more than aware of how its actions affect Canadians and Bay Street. When it comes to future rate hikes, the bank said any decisions will be “predetermined” and guided by upcoming economic data releases and developments in the financial markets. In particular, the Bank of Canada is paying close attention to Canadian indebtedness and the higher costs of borrowing.
“Given elevated household indebtedness, close attention will be paid to the sensitivity of the economy to higher interest rates,” the statement said.
That hardly means a third consecutive interest rate is off the table. In fact, most economists believe the Bank of Canada will raise its rates again when it meets next in October.
The big question is, how will the current rate hike impact the Canadian dollar, the country’s GDP growth, consumer spending, and corporate profits. And what will a third potential rate hike do? Even though rates are still near record lows, any rate hike has the potential to derail any momentum.
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- “Bank of Canada increases overnight rate target to 1 per cent,” Bank of Canada web site, September 6, 2017; http://www.bankofcanada.ca/2017/09/fad-press-release-2017-09-06/.
- “Gross domestic product, income and expenditure, second quarter 2017,” Bank of Canada web site, August 31, 2017; http://www.statcan.gc.ca/daily-quotidien/170831/dq170831a-eng.htm.
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