Central bank in any country is responsible for maintaining stability in the financial system. Central bank is also responsible to implement the government’s planned fiscal policy. There are certain tools available to help the Bank to fulfill its role. Controlling the discount rate is one of the tools in the central bank’s arsenal.
What is Discount Rate?
Central Bank is considered a lender of the last resort. In any country typically, financial institutions borrow from the central bank to stabilize their liquidity situation. The discount rate is the interest rate charged by the central bank to the borrowing financial institutions. These are short-term borrowing generally extended on an overnight basis. Interest charged by the central bank is the borrowing cost for financial institutions.
What happens when the discount rate changes?
The discount rate is used by the Central Bank to encourage or discourage borrowing by financial institutions which consequently have an impact on the credit supply in the country. When the cost of borrowing changes for the bank, it affects the interest rate being charged by the financial institutions to their customer. The intention of changing the discount rate is to impact the money supply and hence the consumer spending in the country.
Since the interest charged by the financial institution depends on the borrowing cost, any change in the discount rate affects the interest charged on credit cards, overdrafts, loans, mortgages or any other form of credit extended to the customers resulting in lowering or increasing the consumer spending in the economy.
The Bank of Canada raised the discount rate in the country from 1.25 to 1.5 per cent in the last week. This was the fourth increase in the last 12 months. Inflation is expected o increase to 2.5% before returning to around 2% by the second half of 2019.
Following the rate hike by the Bank of Canada big 5 banks also increased their prime rates up to 2.95%. The prime interest rate of any bank becomes the basis of calculating the interest rate for any product offered by the bank to its customers. There are other factors which determine the interest rate on a product such as risk factors, credit history, collateral guarantees, etc. But any variation in the prime rate invariably has an effect on the final rate.
What will change for Canadians
1. Cost of borrowing will increase: New credit will become more expensive which discourages people to borrow and spend more money. Spending will generally reduce which will ultimately help with easing the inflationary pressures on the economy. Businesses also put off expansions and other borrowing plans if the expected investment is not expected to generate sufficient returns.
2. Increase in mortgage interest: Home buyers either borrow on fixed or variable interest rate mortgages. Any new mortgages invariable become more expensive with the increase in banks’ prime rates but it also affects the existing borrowers with the variable rates. Their mortgage payments increase in line with the increase in rate. Existing fixed interest mortgages do not get affected by the increase in discount rates but any expected increases and risks are already accounted for when the such mortgages are extended.
3. Decrease in home sales: Increase in mortgage rates discourage people to buy new homes and consequently cools down the property market. Most people consider home buying a long-term investment, and any increase in the mortgage not only makes it less affordable but also results in a reduction in return on their investment.
4. Increased incentive to save: Increase in the prime rates also affects on the savings rates offered by the banks and provides more incentive to people to save rather than spend.
5. Lower consumer spending: Higher interest rates reduce consumer spending and investments and cause fall in the aggregate dements. Lower demand lowers economic growth and eases inflationary pressures on the economy.
6. Increase in value of currency: Due to the increase in interest rates, investors are more likely to save, and it may result in an increase in the inflow of investment in the country which will increase in the value of the currency. Exports will become less competitive and imports will increase.
7. Reduced confidence: Increase in the interest rates reduce the confidence of businesses and consumers alike. It makes them less willing to risky investments and purchases.