When are interest rates going down? And how did Canada get here?

Higher interest rates are starting to bite.

Mortgage renewals are making some homeowners’ stomachs churn and business borrowing is getting quite expensive, prompting some political leaders to take aim at the central bank.

At both the federal and provincial levels, politicians attacked the Bank of Canada for raising rates to five per cent over the past 18 months.

Ontario Premier Doug Ford said the rate increases were causing homeowners and small businesses to wobble, and added that he thought the Bank itself is responsible for high rates of inflation seen in Canada since early 2022.

And B.C. Premier David Eby wrote a letter, saying rate increases are hurting “the middle class and everyone below that,” in the form of higher mortgage payments and rents. 

Federal conservative leader Pierre Poilievre went a step further, saying he’d fire Bank of Canada Governor Tiff Macklem if he was prime minister.

For his part, Macklem told reporters the central bank remains “independent” despite the flurry of criticism it has received from political leaders. 

In his speech earlier in Sept. 2023, Macklem said repeated increases to the key overnight rate are slowly bringing inflation down, but not quite fast enough for his liking.

“Consumer price index (CPI) inflation was 3.3 per cent in July, roughly in line with what we expected in our July Monetary Policy Report,” Macklem told an audience in Calgary. “Our two per cent target is now in sight. But we are not there yet and we are concerned progress has slowed.”

So why did the central bank get down this path in the first place?

Any central bank in a market economy uses its key overnight lending rate – the rate banks obtain cash they can lend out – to influence behavior of players in the market.

When rates rise, borrowing becomes more expensive, as banks have no choice but to pass along the higher rate to new incoming borrowers.

The higher rates also encourage saving. If you’ve looked at your bank’s savings account or GIC (Guaranteed Investment Certificate) rates lately, they’re not so pitifully small as they once were. 

All of this is meant to slow down borrowing and thus cool the rate of inflation, but how do Macklem and the rest of the bank’s leadership decide when enough is enough?

The way the bank calculates whether to raise or lower rates has a lot to do with the Consumer Price Index (CPI). The Bank, (and a whole host of other analysts including Statistics Canada) measure the average price of a variety of goods each month.

They weigh each category (food, shelter costs, energy etc.) and come up with an average rate of price increases throughout the economy.

The Bank’s belief is that when inflation is well above two per cent for a sustained period, it’s worth raising rates.  

But CPI is an imperfect measure of inflation for a variety of reasons.

Consumers can substitute a higher-price item for a lower price one that serves the same purpose.

For instance, at a grocery store, a shopper who balks at the high price of chicken can pick turkey instead. 

There’s also the fact that many products generally increase in quality and capability over time. 

One thousand dollars can buy a much larger and higher resolution television today than it could ten years ago. 

These nuances within the inflation calculation have opened the Bank of Canada up to criticism, with some arguing that the focus on curbing inflation is actually costing the average consumer more in the form of higher financing costs and how rising rates tend to slow overall business activity. 

So, when will rates come back down?

Not all that soon.

A survey of leading Canadian economists released on Sept. 26 found most believe the Bank of Canada will keep its rate at five per cent until at least the third quarter of 2024, but that future rate hikes are not likely. 

The economists also predict rates will reach 3.5 per cent sometime in 2025.