Any country's central bank is responsible for ensuring financial system stability. The central bank is also in charge of carrying out the government's fiscal policy. Certain tools are available to assist the Bank in fulfilling its role. One of the tools in a central bank's arsenal is the ability to control the discount rate.
What exactly is the Discount Rate?
The Central Bank is regarded as the lender of last resort. Financial institutions in any country typically borrow from the central bank to stabilize their liquidity situation. The central bank's discount rate is the interest rate charged to borrowing financial institutions. These are short-term loans that are typically extended on an overnight basis. The central bank's interest rate is the cost of borrowing for financial institutions.
What happens when the discount rate fluctuates?
The Central Bank uses the discount rate to encourage or discourage borrowing by financial institutions, which has an impact on the country's credit supply. When the cost of borrowing for the bank changes, the interest rate charged by financial institutions to their customers changes. The purpose of changing the discount rate is to affect the money supply and, as a result, consumer spending in the country.
Because the interest charged by financial institutions is determined by the borrowing cost, any change in the discount rate affects the interest charged on credit cards, overdrafts, loans, mortgages, or any other type of credit extended to customers, resulting in a decrease or increase in consumer spending in the economy.
Canadian viewpoint
In the last week, the Bank of Canada raised the country's discount rate from 1.25 percent to 1.5 percent. This is the fourth increase in the last year. Inflation is expected to reach 2.5% before falling back to around 2% by the second half of 2019.
Following the Bank of Canada's rate hike, the big five banks raised their prime rates to 2.95%. Any bank's prime interest rate becomes the basis for calculating interest rates for any product offered to its customers. Other factors that influence a product's interest rate include risk factors, credit history, collateral guarantees, and so on. However, any change in the prime rate will invariably affect the final rate.
What will be different for Canadians?
1. Borrowing costs will rise: New credit will become more expensive, discouraging people from borrowing and spending more money. Spending will be reduced in general, which will help to alleviate inflationary pressures on the economy. Businesses also postpone expansions and other borrowing plans if the expected investment does not generate adequate returns.
2. Mortgage interest rate rise: Home buyers can choose between fixed and variable interest rate mortgages. Any new mortgages will invariably become more expensive as bank prime rates rise, but this also affects existing borrowers with variable rates. Their mortgage payments rise in tandem with the rate increase. Existing fixed-rate mortgages are unaffected by the increase in discount rates, but any anticipated increases and risks are factored in when such mortgages are extended.
3. Falling home sales: Rising mortgage rates discourage people from purchasing new homes, cooling the real estate market. Most people consider home ownership to be a long-term investment, and any increase in the mortgage not only makes it less affordable, but also reduces the return on their investment.
4. Increased incentive to save: An increase in prime rates affects the savings rates offered by banks, giving people more incentive to save rather than spend.
5. Lower consumer spending: Higher interest rates reduce consumer spending and investment, causing the aggregate dement to fall. Lower demand dampens economic growth and relieves inflationary pressures.
6. Currency value rise: As interest rates rise, investors are more likely to save, which may result in an increase in inflows of investment into the country, raising currency value. Exports will lose competitiveness, while imports will rise.
7. Loss of confidence: An increase in interest rates reduces the confidence of both businesses and consumers. It reduces their willingness to make risky investments and purchases."""
