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Will Interest Rates Go Down in Canada? A 2023/2024 Forecast

Will Interest Rates Go Down in Canada? A 2023/2024 Forecast

Will Interest Rates Go Down in 2023 in Canada

This article aims to address the prevalent question: “When will interest rates go down in Canada?”. We analyzed data and results from various sources to arrive at our conclusion.

Preamble

Many long-term credit consumers have inquired about the likelihood that the Bank of Canada (BOC) will drop the interest rates.

Well, if you have a similar question, look no further as we will be demystifying this grey area (to help you understand how it works) and providing our predictions on the likely direction of the prime rates.

We based our opinions on a combination of historical data, trends, and administered surveys. Anyways, without much ado, let’s dive into it!

To start with, we will be providing context and explaining some key concepts that would help you understand our perspective even better.

What is the BOC prime rate?

The prime rate is the annual interest rate that all Canadian financial institutions use as a basis to set their interest rates for all credits or loans given out. Prime rates are also referred to as the best interest rate you can get as a consumer or what financial institutions charge their most creditworthy customers.

Financial institutions are at liberty to determine what prime rates to use. Yet, most tend to incorporate the BOC’s overnight rate as the starting point (or operating cost) to arrive at a reasonable prime rate for their credit facilities.

The BOC’s overnight rate is the average interest rate set by BOC for overnight loans between financial institutions.

Most financial institutions determine their credit facility rates based on the prime rates. For instance, Prime +1%.

The additional ‘+1%’ is known as a premium. There are several factors that affect the premium percentage. But, the two most important factors are the riskiness of the product and the creditworthiness of the customer.

The higher the risk associated with the credit facility, the higher the premium (which is +1% in this example). Higher-risk products such as lines of credit and unsecured credit cards usually have higher premiums while less risky products like secured loans, HELOCs, and mortgages have much lower premiums. Lower premiums sometimes tend towards negative values such as Prime – 0.3%.

Am I affected by the prime rate fluctuations?

As mentioned earlier, most financial institutions utilize the prime rate as the baseline for determining their lending rate. In fact, lenders providing new fixed-rate credit facilities, sometimes establish their fixed rates as a “sweet spot” within the range of their variable and prime rates.

Variable interest rates, also known as adjustable interest rates, refer to interest rates that can fluctuate over time. Unlike fixed interest rates, which remain constant throughout the loan or investment term, variable rates are tied to a benchmark or reference rate, such as the prime rate or the Bank of Canada’s overnight rate.

Therefore, if you have any form of variable interest rate credit facility or funds borrowed from financial institutions, you would be affected by a prime rate fluctuation. If you had an existing loan or line of credit held with a fixed interest rate, you would not be affected by the changes in the prime rate throughout your mortgage term.

For instance, variable rates in mortgage lending, lines of credit (such as personal, home equity), and auto loans are usually tied to increases in the prime rate. This implies that there would be a direct relationship between fluctuations in the prime rate and the variable interest rate offered to you by that credit facility.

Let us walk through an example:

Assuming you had a mortgage with a variable interest of “Prime – 0.1” as of 10 December 2022. Your mortgage rate would have been 6.35% (6.45 – 0.1). As of the interest rate change announcement, effective 25 January 2023, your mortgage interest rate would have increased to 6.6% (6.70 – 0.1).

In most cases, dependent on the financial institution, your monthly mortgage payments may be adjusted to reflect the prime rate increases. This is usually done in two ways:

  • Your monthly payment is increased or decreased to ensure the amount that is attributable to the principal remains unchanged.
  • Your monthly payment remains unchanged, however, the portion that goes to the interest component increases while the amount allocated to the principal decreases.

What factors drive the fluctuations in prime rate?

Different financial institutions derive their prime rates based on overnight lending rates (rates banks charge each other for short-term loans). Financial institutions use this as a starting point for establishing the prime rate for customers.

Conclusively, we can say that prime rates are primarily driven by overnight lending (policy) rates.

The BOC is responsible for setting the target overnight rates. This is used as a tool to tackle key macroeconomic factors such as controlling inflation to stabilize the economy.

Inflation

  • A persistent increase in average prices over time.
  • Arises when demand for goods and services far outweighs the economic supplies.
  • High inflation results in loss of purchasing power and reduces the standard of living.
  • High inflation also decreases the value of income and savings and creates lots of uncertainty around overall profitability due to surging costs.
  • Inflation is measured using the changes in the Consumer price Index.
  • When there is a significant deflation below target rate, BOC reduces the policy rates. This results in lower interest on mortgages/loans and less interest on savings thereby encouraging more spending to boost the economy.
  • When there is significant inflation beyond target rate, BOC increases the policy rates. This results in higher interest on mortgages/loans and higher interest on savings thereby discouraging borrowing or spending and consequently, slows down inflation.
  • Note that BOC does not respond to every inflationary change, especially one-off price changes. The focus is mostly on pervasive and persistent changes.

BOC’s Overnight rate

  • This is the average interest rate set by BOC for overnight loans between financial institutions. Also regarded as the cost of funds for the financial institutions.
  • Financial institutions and government agencies lend or borrow money in the overnight market until the next business day when there is a surplus or shortage of funds for their operations.

Prime Rate Trend since 2018

The table and chart below reflect:
  • The historical fluctuations in BOC’s overnight (policy) rates and prime rates in the past five years
  • The relationship between the prime rate and overnight rate
The policy rate changes were set to address inflationary fluctuations and their side effects.
Rate Change Date Prime Rate Percentage Change Overnight Rate
18 January 2018
3.45 %
0.25 %
1.25 %
12 July 2018
3.70 %
0.25 %
1.5 %
25 October 2018
3.95 %
0.25 %
1.75 %
5 March 2020
3.45 %
-0.50 %
0.25 %
17 March 2020
2.95 %
-0.50 %
0.25 %
30 March 2020
2.45%
-0.50 %
0.25 %
2 March 2022
2.70 %
0.25 %
0.5 %
14 April 2022
3.20 %
0.50 %
1 %
2 Jun 2022
3.70 %
0.50 %
1.5 %
14 July 2022
4.70 %
1 %
2.5 %
8 September 2022
5.45 %
0.75 %
3.25 %
27 October 2022
5.95 %
0.50 %
3.75 %
8 December 2022
6.45 %
0.50 %
4.25 %
25 January 2023
6.70 %
0.25 %
4.5 %

Relationship between Prime rate and Overnight rate

No Data Found

Exploring Potential Outcomes had the Prime Rate Not Been Increased

I know the increased rates have been a major source of discomfort to many people especially those with mortgage and other variable loan facilities. However, I believe that the rate increase was inevitable for these reasons: Firstly, inflation would have been harder to curb, and this would have negatively impacted the price of goods and services, reducing your purchasing power and consequently, your ability to save. For instance, there was an upward trend in the Consumer Price Index (CPI) from 0.1 in August 2020 to a peak of 8.1 in June 2022. BOCs policy rate increases impacted the CPI by reverting the trend to a downward movement to about 5.2% in February 2023. Secondly, home purchase prices skyrocketed and persistently grew by an average of 15% from December 2021 to February 2022. BOCs policy rate increases which impacted borrowing rates resulted in the reduced demand for real estate purchases and therefore, the reduction in housing market prices by about 22 – 25% as of January 2023. Thirdly, due to the persistent increase in overall costs between 2021 and 2022, several organizations suffered from smaller bottom lines and lower profit margins. This resulted in a lot of downsizing, tighter labor markets, and reduced productivity.

Overall outlook

Canada has experienced a persistent increase in policy rates from 2.45% in February 2022 to 6.7% in January 2023, which was the highest point the policy rate has been in more than 22 years.

Specifically, in March 2022 (post-pandemic), BOC forcefully raised the policy rate and has since raised it seven times, due to the slowness at which the changes affect inflation. Overall, the impacts of these increases have been felt in different ways such as increased borrowing rates, reduced spending, and tight job markets which have slowly curtailed the inflation rate.

In January 2023, BOC decided to conditionally pause increases to the policy rate on the basis that the economy recovers as expected from the aftermath of the pandemic.

BOC currently anticipates that inflation should drop to around 3% by the middle of the year and attain the 2% target by 2024 due to the slowing economic growth.

Conditions that would prevent further rate increases

  • The way businesses set their prices: This would provide insight into whether the economy is still overheated, or if prices are making predictable progress towards normalcy.
  • Increases in global energy prices resulting in higher inflation.
  • The job market doesn’t cool resulting in increased labor costs which raises overall prices.

How have Canadians reacted to the interest rate hikes (Survey Results)

We conducted a survey to gain insights into the perception of Canadians about the interest rate hikes so far, the impact of the hike on them, and how they have reacted to the sudden unplanned changes.

The survey was administered online and consisted of 10 questions. We received responses from a total of 300 participants across different age groups.

From this survey, 54.3% fall within the 31-40 age range, 42.7% were within the 20 – 30 age range and the remaining 3% were within the 41 – 50 age range. A total of 96.3% of these respondents currently live in Canada.

The following report presents the key findings from the survey.

Key findings

  1. Variable loan owners: Nearly half of the respondents (49.3%) stated that they currently have a variable interest rate credit or loan.
  2. Variable Interest type: The majority of respondents had variable auto loans (40.7%) and variable personal loans (38%). The remaining 21.3% is related to school loans, variable mortgage loans, and other variable credit lines.
  3. Canadians affected by an increase in monthly interest payments: The majority of the respondents (77.3%) have experienced an increase in their monthly interest payments since March 2022.
  4. Dollar ($) impact of Increase in monthly interest payments: Most Canadians have been significantly affected by interest rate hikes. More than half of the respondents (60.3%) reported that they had experienced a monthly interest payment increase of $500 – $1,000 and followed closely, are respondents (22%) who were impacted by a monthly increase of $1,000 – $2,000.
  5. Measures taken to hedge or reduce the impact of interest rate hikes: Most Canadians (85.3%) have adopted measures to hedge or mitigate the impact of interest rate hikes on their personal finance. Prevalent among the measures adopted is “saving for more funds” (which accounted for 55.3%), followed by faster loan payoffs (accounting for 28.7%) and diversification through investment in more assets (19.7%).
  6. Perceptions on the key reason behind the interest rate hikes: More than half (55.3%) of the respondents strongly believe that interest rate hikes are solely the Bank of Canada’s discretion, and they think there is no justification that warrants such increases. Conversely, 23% of the respondents believe that the interest rate hike was majorly caused by inflation.
  7. Perceptions on the possibility of the Bank of Canada raising interest rates further: The majority of respondents (83.7%) believe that they still expect BOC to raise the interest rate even further in the coming months.
  8. Switching from variable to fixed-rate loans to avoid further impacts: A large number of respondents (60.3%) are still fine with retaining their variable-rate loans rather than switching to fixed rates despite the rate hikes. This could imply that Canadians have adapted to the higher interest rates due to hedging measures they have adopted. Only 30.7% are currently considering switching from their variable to fixed-interest loans.
  9. BOC is taking adequate measures to influence factors impacting the cost of living: 84.7% of respondents believe that BOC has been implementing adequate measures to influence factors that impact the cost of living in Canada. This could reflect the increased confidence Canadians have in BOC to impact their cost of living.

In summary, the survey results reveal that the recent interest rate hikes have had significant impacts on many Canadians, resulting in higher servicing costs. 

Although some may argue that there is insufficient justification for the rate increases, Canadians have shown trust in the Bank of Canada (BOC) to address the underlying issues and improve the cost of living.

Additionally, Canadians, while finding the increased costs unfavorable, have remained relatively unfazed.

This is evident in their adoption of strategies to hedge and mitigate the impact, as well as their reluctance to switch to a more stable, fixed-interest rate option. This indicates a level of acceptance and adaptability to the current situation.

Conclusion

In conclusion, based on my assessment of the historical changes in the policy rates, I anticipate that interest rates would remain static at least, until the end of the third quarter of 2023 to enable the BOC to better curb the high spending resulting in persistent inflation.

This should provide ample time for consumer spending to significantly reduce, due to lower purchasing or spending power.

However, I strongly believe that as the inflation rate continues to plummet (towards BOC’s target of 2% by 2024) due to reduced overall demand and spending, BOC would be persuaded to gradually drop the policy rates to attain economic stabilization.

Finally, I foresee that there would be at least a 0.25 – 0.5% decrease in the prime rate within the fourth quarter of the year.

On the goals to reduce the inflation rate, I doubt our ability to attain the target 2% inflation rate in the shortest time, but I do believe that it is likely for policy rates to continue to decrease into 2024.

Frequently Asked Questions

Canada’s current prime rate as of 16 May 2023 is 6.7%

The government adopts several measures to reduce interest rates such as implementing monetary policy that guides how overnight lending rate is adjusted, fiscal policies, price controls, monitoring economic indicators and data analysis and managing international trade.

Yes! BOC has the power to keep the interest rate high as long as it deems fit to control inflation and other economic issues.

Determining if a variable or fixed interest rate is ideal for you would depend on your personal financial situation and goals.

For individuals who are more risk averse and would prefer a fixed monthly payment for the purpose of their budgeting, a fixed rate interest might be ideal.

Alternatively, if you are more risk seeking and don’t mind the risk of fluctuations in interest rates, then variable rates would be ideal for you. However, it is important to note that fixed rate loans usually come at higher rates than variable rates and have a higher prepayment penalty.

Based on our estimates, we believe that as inflation rate continues to drop (towards BOC’s target of 2% by 2024) due to reduced overall demand and spending, BOC would be convinced to gradually drop the policy rates to attain economic stabilization.

Overall, we foresee that there would be at least 0.25 – 0.5% decrease in the prime rate within the fourth quarter of 2023 and further gradual decreases in 2024.

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