Most homeowners – and would-be homeowners – know that the Bank of Canada (BOC) regularly makes announcements about its benchmark “Key Interest Rate.” Those are the days when we find out if the interest rate on variable mortgages is going up, down, or staying the same.
But the BOC also manages Canada’s inflation target – and may be considering a shakeup in order to cope with today’s recovering economy.
The 2 Percenters
If you missed Economics 101, inflation refers to the rising cost of consumer goods over time. In a healthy economy, prices rise almost imperceptibly, so consumers don’t really notice any negative impact from the cost of their cup of coffee going up a dime or that heating their home is a few dollars more a year. But if inflation rises too fast, people’s spending power diminishes drastically. In one of the most extreme cases of “hyperinflation,” over a four-year period in the early 1920s, the value of German currency went from about 90 marks to the U.S. dollar to more than 4-trillion marks to the dollar. In other words, someone with a billion dollars worth of Germany currency in 1921 wouldn’t have been able to buy a cup of coffee with their savings just three years later.
Obviously, no one wants that to happen here. The BOC’s target rate for inflation is 2 percent a year.
Canada’s Inflation Target
In a backgrounder on its inflation targets, the BOC says its objective “is to preserve confidence in the value (purchasing power) of money by keeping inflation low, stable, and predictable.”
In the late 1970s and early 80s, inflation in Canada was in the teens, bouncing up and down from around 5 per cent for the rest of the decade. In 1991, the federal government decided that it would adopt target inflation rates, initially 5 per cent, which it pushed down to 2 per cent. It reached that in 1995, and the target has been left steady in 2001, 2006, and 2011 when the target was reassessed. In 2016, the federal government and BOC will again look at whether or not to change the target rate.
That said, it’s unlikely to raise the inflation rate much, if at all, as high inflation leads to a dangerous combination of consumer uncertainty and speculative investing. Low inflation, on the other hand, makes long-term planning more likely, with both homeowners and businesses investing in housing, automobiles, and infrastructure.
So, how does this relate to your cost of borrowing? Inflation is one of the key measures the Bank of Canada uses when determining how to tweak monetary policy (such as hiking or cutting interest rates). The difference between the BoC’s data and Statistics Canada is the government agency tracks inflation through the consumer price index (CPI). The BOC uses a stripped down version of the CPI that does not include some of the goods and products that experience the most dramatic price swings (fruit and vegetables, gasoline, home heating, etc.) that it calls the “core index.”
One of the things that the bank will potentially be analyzing in 2016 is whether or not to change the mix of goods it uses to track inflation; doing so could help achieve the long-awaited 2 per cent. Reaching that benchmark would set the stage for interest rates – which have been cut twice this year to the current 0.5 per cent – to gradually recover.