How the Bank of Canada’s Monetary Policy Influences Mortgage Rates

How the Bank of Canada’s Monetary Policy Influences Mortgage Rates

The Bank of Canada (BoC) has held its benchmark interest rate steady at 5% for the 6th time since July 2023, a move anticipated by the market. However, the BoC’s announcement was not just about keeping things as they are. It also included an upward adjustment to global GDP growth and a caution about potential inflation risks at home.

The Bank of Canada (BoC) plays a pivotal role in Canada’s economic health by helping to stabilize inflation. This objective contributes to sustained economic growth, a robust labour market, and improved living standards for Canadians. To achieve this, the BoC employs a strategy known as the inflation-control target.

The inflation-control target is a monetary policy where the central bank sets a specific inflation rate as its goal. The BoC’s target is a 2% inflation rate, measured as the 12-month rate (year-over-year) change in the Consumer Price Index (CPI). This target is symmetric, meaning that the BoC is equally concerned about inflation rising above or falling below the 2% target. Although the upper band of the inflation target is set at 3%, the BoC is now trying to wrangle it closer to the lower 2% target to avoid inflation becoming sticky.

Decisions on Interest Rates

The BoC executes its monetary policy by changing the target for the overnight interest rate, commonly referred to as the policy rate. This decision is forward-looking, considering the time between policy actions and their full effect on inflation. The BoC’s policy rate influences Canada’s lending, including fixed and variable mortgages. A cut in the policy rate usually translates to a decrease in variable (VRM) and adjustable (ARM) mortgage rates, making borrowing cheaper and stimulating economic activity. Conversely, increasing the policy rate leads to higher borrowing costs, slowing economic growth. The expectation of the BoC tightening or easing its monetary policy indirectly affects fixed mortgage rates, which are directly influenced by bond yields.

Inflation Trends

Inflation has been a significant concern for the federal government and the BoC since March 2020. The yearly CPI inflation rate began to climb in spring 2021 and hit a high of 8.1% in June 2022. However, inflation has significantly decreased over the last year and a half, dropping to 2.9% in January 2024 and slowing to 2.8% in February. Despite this improvement, the BoC cautions that several factors are contributing to potential inflation risk.

The BoC’s outlook on inflation and upward revision of the GDP growth forecasts significantly shaped the market’s expectations on the timing and extent of future rate cuts. The Bank noted that while inflation remains high, it has eased in recent months, and the easing trend is becoming more broad-based across goods and services. The BoC expects inflation to continue moving closer to the 2% target in the coming year.

US Economic Influences

The global economic climate is one of the factors that the BoC accounts for when making decisions. The BoC’s monetary policy decisions are not made in isolation, as various global economic factors influence them. The Bank forecasts a global economic growth rate of about 3%. In the United States, economic growth has been resilient, fuelled by a strong job market, increasing consumer spending, and robust business and government spending. Given the close economic ties between the two countries, this strength in the US economy has implications for Canada. Global inflation trends could postpone rate reductions in Canada and the US.

US CPI inflation was reported to be 0.4% higher in March, marking a trend of increasing headline inflation this year. The Bureau of Labor Statistics reported that 12-month price growth accelerated from 3.2% in February to 3.5% in March, matching economists’ consensus forecasts. Excluding food and energy, which represent commodities with more volatile prices, the so-called core 12-month reading was unchanged in March at 3.8%. Some items seeing the most significant 12-month leaps in price gains included auto insurance, which soared 22.2%; domestic services, home cleaning, up 10.9%; baby food and formula, up 9.9%; and outpatient hospital services, up 8.3%. On an annualized basis, inflation increased more than expected stateside, causing bond yields to spike and equity markets to sell off. 

Growth Expectation and the Neutral Rate

The BoC’s future outlook is vital to its monetary policy. It forecasts economic conditions, inflation expectations, and the neutral rate, which is defined as the interest rate that balances the economy at full employment and maximum sustainable output. The Bank raised its neutral rate from 2-3% to 2.25-3.25%, which doesn’t impact its decisions in real time but should be used as a guide for where Canada’s monetary policy is headed in the future.

The BoC expects annual economic growth of 1.5% in 2024, 2.2% in 2025, and 1.9% in 2026. The Bank projects inflation to remain near 3% for the first half of this year before moving below 2.5% in the second half, with inflation hitting the 2% mark in 2025. The BoC uses this forecast to guide its policy rate decisions.

Mortgage Rate Outlook

The yield on the Government of Canada (GoC) 5-Year Bond, which greatly impacts the borrowing costs for 5-year fixed-rate mortgages, spiked to as high as 3.73% following today’s announcement. This increase in bond yields puts pressure on mortgage rates to rise. The lower rates seen before the Spring market are likely to face resistance as the GoC 5-year bond yield almost instantly returned to levels seen in early February.

The BoC’s monetary policy decisions directly impact borrowing and mortgage rates. When the BoC cuts its policy rate, lenders usually follow suit and reduce their variable rates as their funding costs reduce. Reducing lender funding costs makes borrowing cheaper and can stimulate housing market activity. Conversely, when the BoC raises its policy rate, lenders typically increase their variable rates, making borrowing more expensive and potentially cooling the housing market.

Looking Ahead

While the BoC has made strides in controlling inflation, it warns that easing too soon could undermine this progress. The BoC anticipates it will be able to start reducing interest rates sometime this year, but officials are divided on when this will happen. Between March 2022 and July 2023, the central bank increased interest rates 10 times, raising its benchmark rate from 0.25% to 5%. However, rate reductions in Canada and the U.S. could be delayed until later this year or next.

The BoC’s monetary policy decisions significantly affect the Canadian economy and its citizens. While the decision to keep the key interest rate at 5% was anticipated, the upward adjustment to global GDP growth and the warning about potential inflation risks were notable in this announcement. These decisions and announcements affect inflation trends, mortgage rates, foreign exchange rates, unemployment, gross domestic product (GDP) and the broader economic outlook. 

As a result, they will continue to be closely monitored by economists, policymakers, and the general public. Borrowers with mortgages coming up for renewal would benefit from contacting nesto’s mortgage experts to see how they can save by locking in their rates before Canada’s bond yields go for another ride.