Higher interest rates are working

Governor Tiff Macklem explains how the Bank of Canada’s increases to the policy interest rate will cool the economy and bring inflation down.

How monetary policy controls inflation

Canadians know inflation is high. But some may wonder why we’re fighting it with higher interest rates.

Monetary policy—raising or lowering the policy interest rate or holding it steady—controls inflation. That’s our main job. We aim for inflation of 2% a year. It’s what we mean by price stability.

When the economy is overheated and inflation is well above 2%, higher interest rates help steer inflation back toward our target. The process takes time, but here’s how it works:

• When we raise the policy rate, banks’ lending rates go up, which makes borrowing more expensive.
• That discourages borrowing—whether it’s mortgages, car loans, lines of credit or business loans.
• Less borrowing means lower demand for housing and for goods and services. In other words, less borrowing results in less spending. It may also mean less investment by businesses.
• Lower demand overall allows supply—the economy’s ability to produce things—to catch up.
• As that happens, inflationary pressures ease and so do expectations about future inflation.

Our interest rate increases are working

Starting in March 2022, we’ve raised the policy interest rate quickly and forcefully—from 0.25% to 4.5%.

And we’re already seeing some impact:

• Borrowing rates have gone up for households and businesses.
• Spending has declined, especially on housing and big-ticket items like furniture and appliances.
• The job market is tight, but small signs indicate that higher rates are starting to cool it down.
• Inflation is falling too—partly thanks to lower global energy prices and improved supply chains, but also thanks to lower demand here in Canada.
• Fewer businesses think high inflation will last. That matters because expectations about inflation affect decisions on prices and wages.

The path forward depends on how things develop

In January, we said we expect to pause rate hikes while we assess the impact of what we’ve done so far.

This pause is conditional: it depends on whether the economy develops as we think it will and whether inflation continues to fall.

With economic growth slowing to close to zero in the first half of 2023, inflation should drop to around 3% in the middle of the year and reach the 2% target in 2024. We’ve already seen inflation come down for the prices of many goods. But inflation in the services sector will take longer to cool.

We’ll be watching to see if the way businesses set their prices continues to reflect an economy that is overheated or if their price-setting returns to normal.

We’re trying to avoid doing too little or too much. And we’re ready to act forcefully again if we need to.

The path to 2% inflation is uncertain

We want to make sure Canadians understand what we’re doing to fight inflation and how this works.

And we know there’s a lot of uncertainty, so we’ll be clear about the risks that could push the economy in a different direction.

On the one hand, inflation could be higher than expected if global energy prices rise. Also, inflation expectations could stay relatively high. And if the strong job market doesn’t cool, increased labour costs could continue to push prices up and make it harder to get inflation to 2%.

On the other hand, higher interest rates in Canada and around the world could slow economic growth more sharply than we anticipate.

With inflation well above our 2% target, we’re most concerned about risks that could push it higher.