Why will interest rates rise in 2022? (2023)

Anyone who owns a home or has been thinking about buying a home has heard a lot about rising interest rates lately. It's a hotly debated topic, with economists and the media watching the Bank of Canada to see what might happen next.

While most people are aware that interest rates are rising and generally understand what this means for them, many may still not fully understand how these interest rates affect the broader Canadian economy.

The average Canadian has little say in the overall course of the Canadian economy, but that doesn't mean they don't need to understand how it all works. Although it may seem like a dry topic, the decisions of our central banks affect us all on an almost daily basis. And while you can't change their choices, understanding the purpose and impact of their decisions can help you make the best decisions for your financial health.

This article will cover the basics that every homeowner or buyer should know, including how interest rates work, why they rise, and what they mean.

What exactly is "interest" growing?

You'll often hear talk of "interest," but it's rarely explained what kind of interest we're talking about. There are hundreds of different interest rates: mortgages, credit cards, investments and more.

More specifically, the "interest rate" in question is usually the Bank of Canada's (BoC's) benchmark rate, also known as the overnight rate or benchmark rate. This rate in particular has the honor of being called "the rate" because it plays a key role in influencing many, but not all, of the other rates in the Canadian financial system.

Essentially, this rate represents the cost to banks of borrowing money from each other from the central bank, which they do every day to rebalance their holdings. In turn, this cost leads to another key rate, ieBank prime rate.Technically speaking, each bank has its own base interest rate, although they try to harmonize them with each other.

The prime interest rate represents the basic cost of borrowing money for consumers and is determined by adding a premium to the overnight rate. That premium covers all other loan costs that the bank has to bear in order to be able to make a profit.

Banks will use the prime rate to determine the interest rate on many of their loans, especially variable rate mortgages. As you can see, bank rates set by the Bank of Canada can have a big impact on the average Canadian.

Other interest rates are also rising, such as fixed mortgage rates, although these rates are not directly linked to the Bank of Canada's key interest rate. You may also hear about inflation rates, which is a completely different story.

Why is the Bank of Canada raising interest rates?

So far we have found that the Bank of Canada has raised interest rates, which has had a downstream effect on many other interest rates. But why would the Bank of Canada raise interest rates in the first place?

The simple answer can be found in the main mission of the Bank of Canada: to keep inflation low. Their goal is to keep inflation around 1% to 3% per year, as measured by the consumer price index. The Bank of Canada's main concern is keeping inflation at a healthy level to keep the Canadian economy moving. They have several different monetary policy tools at their disposal to accomplish this mission, but the most powerful is their ability to set interest rates.

Since the Bank of Canada is the sole issuer of Canadian paper money, it essentially controls the money flowing into the economy. The simplified concept behind inflation is that prices rise due to an increase in the amount of money in circulation to buy the same goods. By controlling exactly how much money enters circulation, banks can help control inflation.

By increasing the cost of borrowing money from banks, they reduce the aggregate demand for money. When interest rates are high, people tend to spend less and save more, which reduces spending and helps slow the rate of inflation.

The causes of inflation are complex, many of which are international factors beyond the control of the Bank of Canada. But there are also domestic reasons. Factors such as public benefits during the COVID-19 pandemic,Rapid growth in house prices, along with supply chain problems that lead to insufficient supply and higher commodity prices fuel inflation. Some might also point out that falling company prices are the cause of inflation. Although it may be some of these, it is not the only cause of inflation, nor is it the biggest.

Fortunately for us, as far as inflation is concerned, we are doing well together. While we cannot control international factors, central banks around the world are also working to contain inflation in their own countries, which should help the overall global economy.

How far will the interest rate increase go?

No one can say exactly how far the Bank of Canada will go in raising interest rates. Current estimates predict that interest rates will continue to rise at least until the end of the year. Since the central bank has made it clear that it intends to lower inflation, it will basically keep raising interest rates until inflation is under control.

So far, inflation is still rising, despite an increase of more than 1% since the beginning of the year. So yes, you can expect the central bank to raise interest rates again, probably several times this year.

Current forecasts suggest that the Bank of Canada's key rate will be between 2% and 3% by the end of the year. That would be in line with rates in the 2000s, but significantly higher than in the 2010s.

In fact, Canadians are enjoying historically low interest rates despite recent rate hikes. Interest rates have been on a general downward trend since at least the 1980s, when interest rates in Canada peaked above 20%.

The last time inflation was as high as it is now was in 1983, when interest rates were around 10%. While we cannot directly compare the state of the economy in the 80s to today, it is clear that higher interest rates are not unprecedented, in fact our current low interest rates are even rarer in the grand scheme of things.

What does an interest rate increase mean for me?

Although the Bank of Canada manages high levels of monetary policy, the effects of these changes can be felt throughout the Canadian economy.

The biggest and most visible impact on Canadians was the rise in mortgage rates. This is especially true for those who bought a home in recent years and took out a variable rate mortgage that was lower at the time.

Rising interest rates are reflected almost immediately in variable mortgage rates, and those borrowers will now begin to see a significant increase in their monthly payments. The situation is exacerbated by the fact that many new buyers enter the market at a time when prices are particularly high, meaning they pay higher interest rates on higher value loans.

If you have a variable rate mortgage, it may be worth considering refinancing or locking in a fixed rate if you feel the increase in repayments is too much to bear. By knowing what's coming, you can do your best to protect yourself from default.

While Bank of Canada rates do not directly affect fixed mortgage rates, other aspects of its monetary policy, such as quantitative easing, can also put upward pressure on rates.Bond rates that help determine those ratesAs a result, homeowners can see an increase when they renovate.

For those with a fixed rate, rates could rise sooner or later depending on the length of your mortgage, while those who bought before 2020 may not see a huge jump if they renew soon. With any luck, this could mean you have time to prepare for increased home loan costs.

As mortgage rates rise, home buyers won't be able to afford the same high prices, so home values ​​could drop somewhat.While the housing adjustment is far from a direct collapse, which can still mean sellers could end up selling their homes for less than they expected.

Higher interest rates also affect many other types of loans. This can include things like home loans and some credit cards. Generally, this will prevent some borrowing in the near future as debt becomes more difficult to repay.

Businesses must also respond to increased borrowing costs. Not only will their costs increase, but the number of customers they have could also decrease. This will encourage companies to keep prices low. In the long run, this helps reduce inflation and is expected to be seen as a positive even after a few painful years.

But if the economy changes too quickly, spending can become so constrained that companies are forced to lay off workers to cut costs. This period of mass layoffs and economic decline is known as a recession, and it is a real possibility in Canada in the near future.

Ultimately, the Bank of Canada is in a bind when it comes to fighting inflation. This could be accompanied by periods of increased costs for Canadian homeowners, reduced purchasing power, potential job losses and more.

Fortunately, the economy works in cycles, and while rising interest rates may be painful now, they will benefit the Canadian economy in the long run. Unfortunately, we are already at a disadvantage, and while it would be better if we weren't here, there is a way out, even if it takes a while to get there. The best thing Canadians can do now is prepare to protect themselves from financial turmoil, reassess their investment risk tolerance and try to spend and borrow less.