| Quick summary: Overnight rate directly affects the prime rate, the rate at which commercial banks loan to their least risky customers. In the US, prime rate hovers 3% above overnight rate (federal funds rate). You can see that relationship here: https://fred.stlouisfed.org/graph/fredgraph.png?g=eY9Y In basic economic theory, when interest rates go up, the economy slows down. Higher interest rates encourage saving/purchasing safe assets, and make lending/investing in risky assets or new business ventures more expensive. Banks generally make less loans that fuel direct economic activity when interest rates are higher. Context/So What: Canada's economy showed strong signs of growth and low unemployment, so the central bank decided to bump up the interest rate a bit while the data supported the decision to "cool off" the economy. OK, so commercial loan interest rates will rise 0.25%. Not a huge deal for majority of the economy. More importantly, the central bank is slowly gaining back the overnight rate as a tool for monetary policy. Many central banks are unwilling to drop the overnight rate below 0%, effectively taxing banks for the reserves they are usually mandated to hold with the central bank.* If the Bank of Canada can continue to bump the overnight rate up to traditional 4-5% level, it can then cut the rate again to spur economic activity in the case of a downturn. The closer the overnight rate is to 0%, the less effective the rate is as a monetary policy tool. Personally I believe it will be a long time before we see 4-5% overnight rates again, but overall this is a reaction to good economic news. It happened before investors expected, so the markets are buzzing about it a bit, even though the small bump will probably not have a large impact on Canada's economy. *BoC actually has no reserve requirements: http://www.bankofcanada.ca/1997/04/working-paper-1997-8/ |
