How the overnight rate affects you, and everyone else
Earlier this month, the Bank of Canada announced that the ‘overnight rate’ was maintaining its stability at 1.75%. This meant that interest rates for investments, GICs, and variable mortgages wouldn’t change. If you’re wondering what the overnight rate is, it’s the interest rate the Bank of Canada wants to see major financial institutions lend each other money at on a one-day, or ‘overnight’, basis. It’s the primary method the Bank has to influence and enact economic policy within Canada, as when the Bank of Canada changes the overnight rate, it causes major financial institutions to adapt their own interest rates on the products they offer.
Major financial institutions adhere to the overnight rate because of two other interest rates, which are set in relation to the overnight rate: the bank rate, and the deposit rate. The bank rate is the interest rate at which the Bank of Canada lends money to major financial institutions on one-day loans. Conversely, the deposit rate is the interest rate the Bank of Canada pays to major financial institutions that leave funds deposited with the Bank overnight. These two rates are both one-quarter of a percent higher and lower than the overnight rate, respectively - as of October 2018 the overnight rate is 1.75%, meaning the bank rate is 2.00%, and the deposit rate is 1.5%. The reason that major financial institutions borrow and lend to the Bank of Canada is due to the way they function as borrowers and lenders. Major financial institutions spend all day lending and borrowing money, and at the end of the day they need to settle those transactions. As often happens, one lender will need money, and another lender will have additional funds left over that it can then lend to the other financial institutions that need additional funds. All of this end-of-day trading happens electronically overnight - hence the name ‘overnight rate’ - through the ‘Large Value Transfer System’, or LVTS. The major financial institutions know that for any trading they do with the Bank of Canada, they will always be charged the bank rate, and paid the deposit rate, meaning they have little incentive to trade outside of those rates. And if the Bank of Canada sees major financial institutions trading outside of that rate, it can always intervene in the overnight market at the target rates, forcefully correcting the market.
As for why the overnight rate changes, there’s a short answer to that question: to control inflation. Changes in the overnight rate in turn affect the rate at which consumers spend and borrow money. This is because when interest rates are low, people and businesses are incentivized to boost their spending and borrowing, which in turn boosts the economy. When interest rates are high, consumers are encouraged to save their money and borrow less. However, this also affects the economy in that changes in borrowing and spending affect inflation. If consumers are borrowing and spending frequently, inflation rises due to more money entering the economy. The Bank of Canada prefers a lower level of inflation that’s stable, and doesn’t vary wildly quarter to quarter. Because of this, the Bank of Canada announces adjustments to the overnight relatively frequently, with announcements happening on a set schedule of between four and eight weeks.
The next overnight rate announcement is on April 24, 2019, and current financial forecasts expect further stability, with the overnight rate continuing to be 1.75%. However, this can change. And if the overnight rate goes up, so will consumer interest rates, including mortgage rates. If you currently have a variable rate mortgage and are worried about the overnight rate increasing, you may want to consider refinancing to a fixed rate mortgage. You can always contact Essential Mortgage Company and its principal owner and broker Myette Raynes here, and we’ll find you a lender that meets your financial needs.
All information herein subject to change and all offers mentioned are subject to change and OAC.