How will the rise in Interest rates effect us?

The Bank of Canada had hiked the interest rate for the first time in seven years by 0.25 per cent, from 0.5 per cent to 0.75 per cent. The increase in the interest rate will have effects on various stakeholders in the Canadian economy, including consumers and businesses. It must be mentioned that the U.S. Federal Reserve also recently increased the benchmark interest rate by 25 basis points from one per cent to 1.25 per cent.

The increase in the interest rate will provide greater incentive to Canadians to save more. The higher interest rate will lead to higher income for depositors in banks, which may encourage people to save more. However, with an increase in interest rate of only 0.25 per cent, the effect on savings is expected to be quite limited.

The higher interest rate may lead to an increase in mortgage rates. This will make it more expensive and, consequently, more difficult for existing homeowners to pay their mortgages. When existing homeowners struggle to pay off their mortgage, it may even push some towards foreclosures. Also, the higher mortgage rate may dissuade prospective entrants from delaying their house purchases. This may lead to less demand for real estate, which may have a dampening effect on high real estate prices. This will reduce the possibility of the creation of real estate bubbles or dampen an existing one.

The higher interest rate has prompted the five banks to increase their prime rate from 2.7 per cent to 2.95 per cent. The higher borrowing cost, including for credit cards and line of credit, may affect consumer spending. It may force consumers to curtail their expenditure on goods and services, and purchase less on credit. However, the Canadian economy has been performing relatively well and employment creation has been quite steady so that the possible adverse effect of higher interest rate on consumer expenditure may be negated.

The higher interest rate will increase the cost of borrowing to invest. This may make Canadian businesses less enthusiastic to borrow to invest or expand their businesses. However, the Canadian economy has performed quite well, which has allowed the Bank of Canada to increase the interest rate. So, it is predicted that businesses will borrow more to invest in spite of the increase in borrowing cost. Also, the potential adverse effect on business investment decisions due to only a 0.25 per cent increase in interest rate may not be that significant.

The higher cost of borrowing will increase the cost of production of goods and services. If businesses decide to pass on this higher cost to consumers, it will lead to higher prices of goods and services. This will increase the cost of living and may even contribute to inflationary pressures. Also, the higher prices of goods and services may make Canadian exports less competitive in export destinations. Imported goods and services to Canada will be cheaper relative to domestically manufactured goods and services, which may make them more appealing to Canadian consumers. However, the possible effect on the prices of goods and services due to a 0.25 per cent in interest rates is predicted to be quite insignificant.

Again, the higher cost of domestic borrowing may prompt Canadian businesses to seek borrowing in other countries. As the U.S. Federal Reserve increased the U.S. interest rate by 0.25 per cent as well, Canadian businesses may not particularly explore the U.S. market to seek lower rates as the interest rate differential between the two countries remain the same as before the interest rate increase. However, the effect may be quite limited as the interest rate has increased by only 0.25 per cent.

Foreign capital may flow in to take advantage of higher interest rates offered by Canadian financial institutions. It may not particularly flow from the U.S. to take advantage of higher interest rates as the interest rate differential between the countries remain the same as before the interest rate increase. However, with only a 0.25 per cent increase in interest rate, the effect on foreign capital inflow to Canada is forecasted to be not significant.

The most profound effect of the higher interest rate is expected to be on real estate purchases.

As cheap money becomes scarce and borrowing becoming expensive, it is predicted that less capital that is financed by borrowing will flow into the stock market. When less funds flow into the stock market, it will dampen the rise in stock prices and reduce the possibility of the creation of stock market bubbles or deflate an existing one.

The higher interest rate has led to an appreciation of the Canadian dollar. It was trading at 78.70 cents U.S. when the rise in interest rate was announced. However, this sudden rise in the exchange rate can be attributed to the panic created by the higher interest rate. It is expected that this sudden surge in the Canadian dollar will subside as the markets adjust to the higher interest rate unless other factors contribute to the appreciation of the Canadian dollar.

The increase in the interest rate is predicted to have some effects on Canadians. It could incentivize Canadians to save more, reduce their expenditure and borrow less than before. However, an increase of only 0.25 per cent in the interest rate is predicted to have quite limited effects on Canadians’ savings, expenditure and borrowing habits. The most profound effect of the higher interest rate is expected to be on real estate purchases.

With higher mortgage rates, the demand for house purchases may decline that may stem the rise in real estate prices. Also, the higher borrowing cost may diminish the interest of Canadian businesses to domestically borrow to finance their business operations, and increase their interest in seeking financing abroad. Moreover, the higher cost of borrowing may lead to higher prices of goods and services. But, the effects will be quite minimal as the interest rate has increased by only 0.25 per cent. The effect on inflow of foreign capital is predicted to be not substantial as well. Finally, higher borrowing cost may lead to less borrowed capital flowing to the stock market, which may limit the rise in stock prices and diminish any possible stock market bubbles.

Salman Sakir
Economist

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