Eight times a year, the attention of Canada's financial world collectively turns to the governor of the Bank of Canada. On those select days — always a Tuesday — the central bank boss issues a short statement in the morning that attracts an extraordinary amount of scrutiny from a gaggle of analysts and bankers.

Why all the attention? It's because these statements are all about interest rates. This is where bankers, business people, homeowners and debtors all find out if the cost of money is going up or down — now and in the near future.

Raising and lowering interest rates is the Bank of Canada's primary tool to either jump-start the economy or try to cool it down. This is when Canadians find out if the interest rates on their variable mortgages or lines of credit are changing. 

What is the 'overnight rate'?

The overnight rate is the interest rate at which banks borrow and lend one-day (or "overnight") funds among themselves. The Bank of Canada sets a target level for that rate, which is often referred to as the Bank's key interest rate or key policy rate.

The chartered banks base their prime lending rates directly on the overnight rate. Currently, the prime rate is 3.00 per cent. Changes in the prime rate immediately lead to similar changes in rates for variable mortgages and lines of credit. 

 

Source: Bank of Canada

These days, the talk is all about the cost of money going up. The Bank of Canada's current overnight lending rate — the benchmark that everyone watches — is at just one per cent, even after three small increases of a quarter of a percentage point each in 2010.

That's still very low by historical standards — a deliberate policy decision by the central bank to encourage borrowing and re-inflate the economy after the bruising recession that began in late 2008. 

With the economy now growing again and unemployment gradually falling, the Bank of Canada is now weighing a tricky decision — when and how quickly to resume rate hikes.

Too soon and too fast and it runs the risk of snuffing out the nascent recovery. But wait too long or hike too slowly and the steady supply of still-cheap money runs the risk of overheating the economy — a reality that typically manifests itself through unacceptably high inflation.

That's the delicate balancing act Mark Carney faces. And he has no shortage of critics — professional and amateur — with their own thoughts on the matter.

Why raise rates?

The main argument in favour of immediate and steady rate increases is that inflation is already above the central bank's stated comfort range of one to three per cent annually (3.3 per cent as of April). That thinking was behind the recent "raise rates now" recommendation of the C.D. Howe Institute's Monetary Policy Council.

The Organization for Economic Co-operation and Development notes that, at one per cent, Canada's key lending rate is still "highly stimulative." The OECD said the Bank of Canada should soon resume raising interest rates "at a moderate pace."

But the consensus among central bank watchers is that Carney won't be in any rush to raise. This crowd cites a number of factors:

  • Economic growth (which was running at an annual pace of 3.9 per cent in the first quarter) is expected to soften in the next few months, largely because of supply chain disruptions to Canada's auto sector caused by the Japanese earthquake disaster.
  • Canadian households remain highly indebted (the average family debt-to-income ratio has hit a record 150 per cent, the Vanier Institute of the Family reported earlier this year). Those debts are already causing many to cut back on their spending, with consumer spending flat or even negative earlier this year. Dramatically higher interest rates would weaken the ability of many families to cope.
  • The Canadian dollar — already above parity with its U.S. counterpart — is hurting the competitiveness of Canadian exporters. Increases in the key interest rate in Canada, in the absence of similar increases south of the border, would drive the loonie even higher.
  • Stimulus spending by the federal government largely wound up a couple of months ago and the drive by all governments (federal and provincial) to cut back on spending in the future to eventually balance their books will be a drag on growth.
  • The global economic picture is gloomier than it was a few months ago as the sovereign debt crisis sweeping through parts of Europe (notably Greece) keeps rearing its head. Growth in China is also moderating and, in the U.S., high unemployment levels and a persistently weak housing market are expected to continue to keep consumers cautious.
  • While it's true that total CPI inflation in Canada is running at a hot 3.3 per cent, the core rate of inflation, which excludes such volatile items like energy and fresh fruit and vegetables, is just 1.6 per cent — not a level that the Bank of Canada needs to immediately worry about.

Faced with all the economic push-and-pull, analysts were almost unanimous in their views that the central bank's key rate wouldn't move on May 31. That was quite a change from just a few months ago, when many analysts were calling for a May hike. But that was then. While a few analysts are now calling for a July rate hike, most say that Mark Carney will likely hold off on making any hike until the fall. 

"Recent communications from Bank of Canada officials suggest that they are not in a rush to raise interest rates in light of their growing concerns about developments such as the high Canadian dollar and the uncertain global economic climate," reads a recent briefing note from TD Economics. 

The watchwords for the Bank of Canada — at least for the medium term — seem to be for a gradual phase-out of its low interest rate policy.

Look for an overnight lending rate of perhaps 1.75 per cent by the end of the year and a more "normal" overnight rate of three per cent by mid-2012, the markets are saying now. 

But that will depend on how the governments, consumers and economies of the world behave in the months to come.