In recent times, you may have come across news about rising inflation rates in Canada. In June 2022, Canada experienced a significant increase in its inflation rate, reaching a peak of 8.1%. Simultaneously, the interest rate was increasing rapidly and soared to a record high of 4.5% in January. However, have you ever wondered why an inflation rate of 8.1% is considered high? The inflation rate was over 80% in Turkey during the same period with an interest rate of 14%. This blog aims to demystify the link between inflation and interest rates, shedding light on their impact on our daily lives.
In December 2022, Tiff Macklem, the Governor of the Bank of Canada, delivered a speech affirming the bank’s commitment to resolutely combating inflation by raising interest rates. To demonstrate their determination to meet the two percent inflation target set since the early 1990s, the Bank of Canada has increased the policy interest rate by 425 basis points, elevating it from 0.25% to 4.5% since early March 2022. The bank anticipates maintaining this rate but stands ready to raise it further if necessary to sustain the target rate.
According to Statistics Canada, the Consumer Price Index (CPI) recorded a year-over-year increase of 4.4% in April this year, following a 4.3% rise in March. This acceleration in headline consumer inflation marked the first significant increase since June 2022. The unexpected surge in Canadian inflation, combined with a rise in housing activity, has left economists divided on whether the Bank of Canada will raise interest rates in the coming months. This latest data will be a crucial factor for the central bank’s decision-making process during their upcoming rate meeting.
Several economists have predicted a 25-basis point hike in interest rates next month based on the persistence of inflation. These forecasts consider the Bank of Canada’s objective of maintaining price stability and ensuring long-term economic growth.
To comprehend the decisions made by the Bank of Canada and the forecasts put forth by economists, it is essential to grasp the connection between interest rates and inflation. In simple terms, interest rates are used as a tool by central banks to manage inflation. When inflation rises, central banks may increase interest rates to control spending and curb the economy. Higher interest rates make borrowing more expensive, which reduces consumer spending and investment, thereby aiding in controlling inflation.
Additionally, it is crucial to consider expected real interest rates. Expected real interest rates take into account inflation by subtracting the expected inflation rate from nominal interest rates. They represent the true return on investment or the real cost of borrowing. When making significant financial decisions such as taking out a mortgage, understanding the impact of inflation-adjusted dollars is essential. For instance, a difference in the expected inflation rate of 2% and 4% over a 10-year mortgage of $300,000 can amount to over $63,000 in inflation-adjusted dollars. Therefore, it is vital to carefully consider future economic performance when making such decisions.
The relationship between inflation and interest rates plays a pivotal role in shaping the economic landscape. In Canada, the recent rise in inflation has prompted the Bank of Canada to take measures to maintain price stability. Understanding this relationship empowers us to comprehend the decisions made by central banks and their impact on borrowing costs, investment opportunities, and our everyday lives. Stay informed about these factors to make sound financial decisions and navigate the ever-changing economic landscape.
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