Explainer: The Strategy Behind Rising Rates

As Canadians navigate inflation amid economic uncertainty, many are asking fundamental questions about the Bank of Canada’s policy strategy.

The answer comes down to consumption behavior.

The Bank of Canada (BoC) said on its website that “higher interest rates encourage savings, discourage borrowing and, in turn, discourage spending.” “In response, companies will slowly raise prices or lower them even further to stimulate demand.”

To reach its inflation target, the BoC will adjust policy rates, encourage banks to raise interest rates on deposits, loans and mortgages, and start a chain reaction in the exchange of goods and services.

To measure monthly inflation, Statistics Canada tracks the prices of consumer goods and services, all of which contribute to the so-called “consumer price index” (CPI). This measure represents a “big picture” of spending across Canada, and this data is commonly considered by businesses, institutions and governments to understand their financial trajectory.

Expectations are a key component of the inflation problem.

“If prices are expected to rise by about 2% annually on average, employers and workers are more likely to agree to a 2% wage increase to compensate for the rising cost of living,” the Bank of Canada said. said. “And because wages affect the cost of producing goods and services, and costs affect their prices, this cycle helps banks keep inflation on target.”

Simply put, when the cost of goods exceeds people’s income, people buy less and the economy slows down. General purchasing power falls across the economy.

“High inflation could mean that people who have saved for retirement may find themselves with less money than expected,” said the BoC. “Businesses and consumers must invest time and effort to protect themselves from the impact of rising costs.”

But just as bad as high inflation is deflation, when prices plummet.

“Lower prices for some items may boost demand for those items,” said the BoC. “However, a sustained decline in prices across the board is usually a sign that the economy is in serious trouble.”

For this reason, the BoC also leverages interest rates when it comes to enabling more spending.

“Low interest rates can work the opposite way, and too low can drive inflation.”

It all comes down to purchasing power and the dynamics behind it, explains the BoC. When people lose their jobs, they have less money to spend. As a result of this, if a business’s sales decline, prices may fall, but that’s a result of lower demand.

“As more money accumulates, less money is spent, prices fall further, and economic activity shrinks.”