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Break it down for me: How does the key interest rate influence inflation?

December 7, 2022

These days, everyone's talking about the rising cost of groceries, rent and other services. You've probably noticed it too—everything costs more! And that's to be expected, because inflation is currently 7%, way above the 2% target. We also hear that increasing the key interest rate is a solution to this surge in prices. But what is this infamous rate and how does it affect the cost of living? That's what I asked Hendrix Vachon, Principal Economist at Desjardins Group.

A text by Audrey Pigeon, youth reporter for Desjardins

First, Mr. Vachon explained to me that the key interest rate is a rate set by the Bank of Canada to control price increases. The Bank of Canada is the only one in the country that can change the rate to keep inflation at about 2%.

But why 2%? The Bank of Canada explains: "In our experience, inflation tends to be close to the 2% target when the economy is running near its capacity—when demand for goods and services is roughly equal to what the economy supplies."

"Inflation is basically an imbalance between supply and demand," says economist Hendrix Vachon. "It's when there's more demand for goods and services than what we can produce."

Mr. Vachon explained to me that the Bank of Canada's goal right now is to reduce demand by limiting our purchasing power. By increasing interest rates, people can afford to borrow less. As a result, some costly projects get cancelled or postponed and people hang on to their money instead of spending it. Saving instead of stimulating the economy creates lower demand and eventually lower inflation.

Getting back to normal can take 6 months to 2 years. According to Mr. Vachon, we need to be patient, as time is usually on our side.

What other factors influence inflation?

International issues also have a significant impact on inflation. According to the Bank of Canada, two-thirds of current inflation is a direct result of international issues. For example, the war in Ukraine has caused increases in the price of oil and the pandemic created supply chain problems. The remaining third is due to strong demand from Canadians for goods and services that weren't necessarily available during the pandemic. The good news is that nothing is set in stone.

"During the pandemic, we had major disruptions in supply chains," explains Hendrix Vachon. "We expect these disruptions to subside and that will help [reduce inflation]."

According to the economist, companies are expected to gradually adjust their offerings. At the same time, as interest rates rise, demand is expected to drop. These are encouraging signs for a return to a balanced supply and demand situation.

What does it all mean for you?

An increase in the key rate means that the interest rates at your bank will also go up. In other words, borrowing rates and mortgage rates will follow suit. The good news is that increasing them now will do less damage than staying on the inflation treadmill. So, with the key rate rising to encourage everyone to save, why not give it a try!

Audrey Pigeon is a youth reporter for Desjardins. Her role is to create original content that covers social issues from a youth perspective.