COLUMN: Ask the Money Lady – Bank of Canada lesson

Dear Money Lady Readers:

Most people are taking summer vacation this year and actually going somewhere – yes, according to a Canadian IPSOS Study (May 2024), eight out of 10 Canadians say they really need a holiday this year. While many Canadians feel the urge to travel this summer, more are also scaling back their vacation plans due to inflation. In short, IPSOS says: “more will travel, but many will try to spend less.”

Inflation has been trending down month over month and we all seem to be doing our part to reign in the spending which will help to lower the Canadian Prime Rate – a welcome reprieve to those still holding a variable rate mortgage. The BOC (Bank of Canada) will have three more opportunities to lower the rate from 4.5 percent (September 4, October 23, and December 11). If all goes well and they drop a quarter point each time, that could bring us down to 3.75 percent.

But if the BOC rate is currently at 4.5 percent, why is the Canadian Prime rate at 6.7 percent (July 2024)?

Well, the BOC rate manipulates the outcome of the rates, but it does so through its involvement with our financial institutions. It is the Canadian Banks that set the Prime lending rate and here’s how it’s done.

The prime rate has always been influenced by the policy interest rate set by the BOC which is also known as the target overnight rate. You see, the Canadian banks process their daily transactions overnight and borrow, trade and transact with each other during closed business hours. This is called the overnight market that operates much like an automated clearing house, transferring debits and credits between banks nationwide. All financial institutions operate this way during the night cycle to process all money transactions in Canada and around the world. The overnight rate is very important to financial institutions who will aggregate funds and borrow as needed to process and settle internal bank transactions. In order to process the large number of payments and transactions simultaneously, most institutions will run into issues clearing at the end of each day. Banks may not have enough deposits in a day to cover what needs to go out. Some financial institutions may have sent out more in payments than they received, while others may have received more than they sent out. This is why the BOC rate is so important. Every night while we sleep, the Canadian banks borrow money from each other in the overnight market at a centralized cost, (the BOC overnight lending rate). A financial institution doesn’t always have to borrow or lend to other banks, they can also use the BOC for one night. These rates vary overnight for deposits and loans to the banks based on the BOC operating band.

So why the “banking financial lesson?” Well, knowing how the banks transact with one another helps us understand why the BOC rate is so important. When our Canadian banks borrow and lend together, they basically keep our Prime rate consistent among all financial institutions across the country. This ensures the loan and mortgage rates we pay are based on a unilaterally agreed upon Prime Rate (currently at 6.7 percent) and the interest rates paid on GICs are generally the same across all Canadian markets. The two percent BOC threshold remind us – “to keep inflation at two percent” – and this has always been the BOC’s magic number. Below two percent means they will lower rates to increase spending and increase the economy, above two percent and they will raise the rates to force us to spend less and slow down the economy. We’re almost there. At the end of July, inflation sat at 2.7 percent. With three more potential drops, we are all hoping Prime will come down to 5.95 percent by December. (The BOC has eight fixed dates per year where it will either raise, lower or maintain the rate). Most economists predict we will be under six percent by 2025…..so fingers crossed, they’re right!

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Christine Ibbotson is a Canadian finance writer, radio host & YouTuber. For more advice check out her YouTube channel: ASK THE MONEY LADY – Your Canadian Finance Coach.