Why Are Interest Rates Soaring, and Will They Continue?

By Josh Sherman | 5 minute read

With the Bank of Canada hiking its key interest rate on seven consecutive occasions since March 2022, economic policymakers have been busy pulling the levers.

The central bank’s key interest rate impacts everything from credit-card debt and student-loan repayments to lines of credit and, of course, mortgages — and it leapt from 0.5% to 4.25% in just 10 months (UPDATE: As of June 5, 2024, the overnight rate stands at 4.75%).

“There’s nobody that can escape this,” says Moshe Lander, senior economics lecturer at Concordia University, of hikes to the key rate (also known as the overnight rate). “Any time that you see somebody borrowing money, they are directly influenced by the decisions of the Bank of Canada to increase the overnight rate,” he tells Wahi.

Ahead of the BoC’s first scheduled rate announcement of the year on January 25, Canadians are — no surprise — stressing out over debt as they face skyrocketing borrowing costs. Just look at the latest quarterly reading of the MNP Consumer Debt Index: A record 47% of Canadians are worried about their debt, up seven percentage points from the previous quarter.

Shockwaves have also been sent through the real estate sector, the single biggest component of the Canadian economy. Home sales were down 39.1% on a year-over-year basis in December, while prices dropped 7.5% annually, according to the Canadian Real Estate Association.  

However, experts suggest that short-term pain is necessary to get Canada’s economy back on track — and sidestep the dangers of runaway inflation. (According to StatCan’s Consumer Price Index, a measure of goods and services costs over time, inflation peaked at 8.1% in June, well above the BoC’s 2% target.)

What Good Are Higher Interest Rates?  

Rate hikes are the Bank of Canada’s main tool to bring inflation back down to earth. “The overnight rate is the key policy lever used by the Bank of Canada to impact demand,” Marc Desormeaux, principal economist at Desjardins, tells Wahi. “Borrowing costs go higher — that has an impact on demand. That’s intended to cool the economy in a way that helps slow inflation, and that’s what’s going on right now,” he adds.

Inflation means the prices of goods and services are increasing; by hiking interest rates, the Bank of Canada discourages spending and borrowing, thereby reducing demand — and, consequently, prices — in an economy. It’s the law of supply and demand in effect. (Conversely, the central bank can kickstart a sluggish economy by trimming rates, which matched a record low of 0.25% in the pandemic’s early days.)

Why Are Interest Rates Rising so Fast?  

Signs of more rapid inflation were emerging during the pandemic, but, with lockdowns and other COVID-19 restrictions already battering the economy, the Bank of Canada had its hands tied. “What the Bank of Canada did then was they held their nose, they looked the other way, and they allowed inflation to go above their target — and probably to an uncomfortably high level,” says Lander.

As the economy reopened, though, the central bank began taking decisive action to tackle inflation, which had worsened due in part to supply-chain issues. “They had to move aggressively to make up for lost time. Where they might have done this gradually over a period of years, instead they were forced to do it all within one year,” Lander explains.

Aggressive monetary policy isn’t without risk. Set rates too high, and policymakers can trigger a serious recession. However, a recession is the lesser of two evils, Lander suggests.

“An economy will always recover from recession,” he says. “An economy will probably recover from inflation, eventually — but the damage of inflation is much greater than the damage of recession, and so the Bank of Canada had to move really quickly to make sure that the inflationary risk was contained.”

Where Are Interest Rates Headed?  

Suppose the Bank of Canada held steady with interest rates moving forward. The effects of the past several hikes could still spill into 2024 or 2025, suggests Lander: “Canadians need to realize that it takes a while for these interest rates to fully work their way through the economy.”

For instance, borrowers with fixed-rate mortgages won’t see higher monthly payments until they renew their terms, which could be years away depending on when they signed their contracts. 

“We’re still in the early days of seeing what’s going to happen,” says Katchen. “These cycles usually take between 18 months and three years to get to a new normal,” he adds.

Meanwhile, Lander and Desormeaux agree at least one more rate hike is on the way this year, and they both expect policymakers to act this week. “The Bank of Canada will likely (and should) increase the overnight rate by 25 basis points,” says Lander.

The economy is showing resilience in terms of unemployment and GDP, for instance, suggesting it “can absorb another rate increase” he says. “There may be one more increase of 25 basis points in the first half of 2023, but I expect after that it will be to hold rates and let all the previous increases do their work.”