A Guide to How Inflation Influences Interest Rates

The Bank of Canada (BoC) aims to keep inflation around 2%. And the primary tool used to control this involves adjusting its benchmark interest rate, which, in turn influences bank prime rates – the rates that control variable interest rates, including variable-rate mortgages. Quantitative tightening or easing, which impacts government bond yields, is used to control fixed-rate mortgages.

Key Takeaways

• The primary tool used by the Bank of Canada to control inflation involves adjusting its benchmark interest rate, which, in turn influences variable-rate loans
• The Bank of Canada either uses quantitative easing or tightening when inflation is too low or high so government bond yields decrease or increase, which impacts fixed-rate loans
• Interest rates, like many things including the housing market, are cyclical – meaning they always have their highs and lows that balance out over time

What causes inflation? 

Inflation is a measure of how much prices for goods and services are rising. Many factors affect prices – including such things as how difficult a product is to find, the cost of labour and the raw materials used to make it as well as competition among the places selling it. Policies that stimulate economic growth can cause inflation as well. When people have more money, their demand for products and services can rise, and that can pull up prices.

In setting monetary policy, the BoC looks at core inflation measures that reflect the underlying trend of inflation over time.

How are interest rates impacted by inflation?

One of the BoC’s core functions involves setting monetary policy. The objective of monetary policy is to preserve the value of money by keeping inflation low, stable and predictable. This allows Canadians to make spending and investment decisions with more confidence, encourages longer-term investment in our economy, and contributes to sustained job creation and greater productivity. This, in turn, leads to improvements in our standard of living.

And in order to keep inflation on target – around 2% – the BoC adjusts its benchmark interest rate, which, in turn influences bank prime rates – the rates that control variable interest rates, including variable-rate mortgages. In other words, when inflation is too high, interest rates are raised over time. And, on the flip side, when inflation is low, interest rates are lowered over time.

During times of low inflation, the BoC also buys government bonds, which raises their price and lowers their return to help stimulate the economy. This is known as quantitative easing (QE). On the other hand, when inflation is high, quantitative tightening (QT) is used to help pull back that extraordinary support by reversing the purchases. 

QT complements the BoC’s primary policy tool – the policy interest rate – which influences short-term borrowing costs. QT removes a source of downward pressure on interest rates that isn’t needed when the economy is doing well. This helps bring demand and supply back into balance and inflation back toward the 2% target.

With QT, the BoC either lets its government bonds mature and roll off the balance sheet or actively sells them. As a result, bonds become cheaper and their yields increase. Because other interest rates in the economy are influenced by government bond yields (including fixed mortgage rates), QT makes borrowing more expensive. 

Important: When interest rates are higher, households and businesses tend to borrow and spend less, which eases demand on the economy, helping soften inflationary pressure

What are the impacts of higher interest rates on borrowing money?

Higher interest rates mean that borrowers will pay more over time for mortgages and other loans. 

While fixed-rate mortgage payments remain the same throughout the term of the loan, borrowers can expect to pay more in interest upon renewal if rates remain higher. 

And with variable-rate products, borrowers either face higher payments right away or the mix between principal and interest of the loan is adjusted so that more money is paid towards the interest component when rates are higher.

Did you know… Every five years, the Bank of Canada and the Government of Canada review and renew the agreement on Canada’s monetary policy framework? In 2021, they renewed the framework for 2022-2026

How can a borrower navigate times when inflation and interest rates are high?

Interest rates, like many things including the housing market, are cyclical – meaning they always have their highs and lows that balance out over time. 

Monetary policy actions take time – typically between six and eight quarters – to work their way through the economy and have their full effect on inflation. For this reason, monetary policy is always forward looking and the policy rate setting is based on the BoC judgment of where inflation is likely to be in the future, not what it is today.
This means that borrowers must be patient and wait for rates to decrease again.