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10 December

More Interest Rate Games

Yesterday the Bank of Canada lowered the target for the overnight rate by 75 basis points (0.75%) to the lowest level in 50 years. This was a little bit of a surprise move as only a 50 basis point move was expected. The Bank of Canada also said that the Canadian economy is now in a recession. The reason a central bank (like the Bank of Canada) lowers interest rates is so that borrowing money is cheaper (and saving money is less profitable) which makes it easier for businesses and individuals to spend money because either it costs less to borrow it or it isn't as attractive to save it. So what did the Canadian banks do? They lowered their prime interest rate by 50 basis points, holding back 0.25% of the Bank of Canada interest rate cut from consumers.

Let's take a quick look back over what has happened to interest rates during the last few months. On September 3 the Bank of Canada in its scheduled interest rate announcement kept the target overnight rate at 3%. At that time most Canadian banks had a prime rate of 4.75%. So the spread between the prime rate and the overnight rate was 1.75%. On October 8 in a move coordinated with central banks across the globe the Bank of Canada cut the target overnight rate by 0.50% to 2.5%. Canadian banks balked at this move and only lowered their prime rate by 0.25%. On October 10 the Canadian federal government announced that through the CMHC (Canadian Mortgage and Housing Corporation) they would be providing funding to insure $25 billion worth of mortgages, basically taking the banks off the hook for mortgages that may go bad. This prompted some interest rate moves by the Canadian banks, some of them lowering their prime rate by 0.25% and others lowering by 0.15%. Then on October 21 the Bank of Canada released a scheduled interest rate decision lowering the target overnight rate by 25 basis points to 2.25%. While the Canadian banks took their time announcing interest rate cuts by 6:00 on October 21 all the banks had lowered their prime interest rate to 4%, maintaining the 1.75% gap between the prime rate and the overnight rate target. Yesterday was the next Bank of Canada interest rate move and the banks have decided that they need a 2% spread between the target overnight rate and their prime rate, the prime rate is at 3.5% and the target overnight rate is now at 1.5%.

This 0.75% move by the Bank of Canada was slightly unexpected so I wonder if the banks were prepared to do a 0.5% cut at most, only counting on a 0.5% move by the Bank of Canada. The next scheduled interest rate announcement by the Bank of Canada is on January 20, 2009. It will be interesting to see what happens between now and then in the economy and how the Bank of Canada and the Canadian banks respond on January 20.

posted at 09:27:13 on 12/10/08 by 0xCC - Category: Personal Finance

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