Bank of Canada raises rates, but sees soft recovery

Hike will be noticed immediately by those who have variable mortgages, lines of credit

By Fiona Anderson, Vancouver Sun September 9, 2010

The Bank of Canada raised its benchmark lending rate Wednesday, the third increase in just over three months.

The bump of 25 basis points brings the bank's target rate for overnight loans between financial institutions to one per cent. Canada's largest banks followed suit by raising their prime lending rate to three per cent.

The increase in prime lending rates will be noticed immediately by anyone with loans -- like variable mortgage rates or lines of credit -- that calculate interest according to the prime rate.

People with big lines of credit "are the people who are going to hurt," said Andrey Pavlov, associate professor of finance at Simon Fraser University.

But that's what the Bank of Canada was thinking when it raised the overnight rate, he said. The bank wants to slow consumption and it does that by hitting those who consume the most.

"Now they're not out there to hurt anyone in particular, but they do need to slow down the economy because if we grow too fast we're going to get inflation," Pavlov said.

But whether fixed mortgage rates will be affected is a different story. While the central bank has been raising its overnight rate since June, commercial banks have been lowering mortgage rates.

"So it doesn't necessarily mean that the fixed rate will go up," said Tsur Somerville, director of the centre for urban economics and real estate in the Sauder School of Business at the University of British Columbia.

"But it certainly means the variable-rate mortgages will go up [and] so by definition it has to dampen the housing market."

With the higher variable rate there will be some downward pressure on house prices, he said. But at the same time, the strengthening economy should have a positive effect on the market.

"And the strength of the economy is going to be a more important factor for the housing market," Somerville said.

Despite the rise in variable rates, and the uncertain effect on fixed-rate mortgages, Pavlov believes that variable-rate mortgages are still the way to go, especially since he believes this rate increase will be the last for some time to come.

"I wouldn't be surprised to see another year with no further increase," Pavlov said.

So although people who took out a variable-rate mortgage six months ago or a year ago now are paying a little bit more compared to a fixed-rate mortgage they could have taken out six months ago, they are still way ahead, he said.

"If [rates] do hold for another year you'll surely be ahead regardless of what happens afterwards because you're paying down your mortgage. You should be keeping your payments high; then even if interest rates go up they are going to be on a lower balance," Pavlov said.

But whether the Bank of Canada will hold rates steady or not is an open question. In its announcement, the central banker said economic activity in Canada had been softer than expected and that the economic recovery was now expected to be slightly more gradual than projected. But it also said "consumption growth is expected to remain solid and business investment to rise strongly."

As a result, "any further reduction in monetary policy stimulus would need to be carefully considered in light of the unusual uncertainty surrounding the outlook," the bank said.

Douglas Porter, deputy chief economist at BMO Capital Markets, called the central bank's statement "a bit more hawkish than we expected."

"The Bank of Canada clearly retains its tightening bias, and seems generally unfazed by the recent cooling in the Canadian economy," Porter wrote in a note. "While we had been expecting the bank to now move to the sidelines for a spell, it appears that it will take a deeper slowdown in domestic spending ... than what we have seen so far to prompt them to stop raising rates."