Bank of Canada has raised its policy rate that sets the direction in an attempt to calm inflation. Here is a breakdown of what the rate does, and what the increase—likely the first of multiple rate hikes this year—means for households, businesses, and governments.

What is the key policy rate and what does it do?

The key policy rate, also known as the overnight rate target, is the interest rate that the Bank of Canada wants commercial banks to charge when lending money to each other overnight until balances are settled at the end of each day. Knowing how much it costs to lend money between institutions, or to deposit money at the Bank of Canada, helps determine the commercial interest rates charged on things like loans and mortgages.

How does raising interest rates help to calm inflation?

The key rate is also the Bank of Canada’s primary tool to manage inflation. When the economy is sluggish and inflation rates are low, the bank lowers the rate to encourage spending. Raising rates has the opposite effect by reducing spending when inflation rises above a certain point for the Bank of Canada between one and three percent. Rate changes can have some immediate effects, but the impact on inflation rates usually takes between six to eighteen months to appear.

What does a rate increase mean for households and businesses?

Ratehub.ca and mortgage rate averages indicate that homeowners with variable-rate mortgages are likely to see an increase in mortgage payments since the base interest rate banks charge generally moves with the central bank’s key rate. For those with fixed-rate mortgages, the impact of rising costs will not be felt until renewals in the coming years.

Royce Mendes, Chief Macro Strategist at Desjardins, said that higher central bank interest rates tend to dampen demand for houses and durable goods like cars, appliances, and home electronics, which consumers heavily spent on during the pandemic.

Mendes says that raising the interest rate alone will not immediately change spending habits. It will likely require further increases and a decline in virus transmission to cool spending on goods as part of a shift toward spending on personal services.

Does this have any effect on federal finances?

The federal government said in its fall economic update that a one percentage point increase in interest rates reduces the budget balance by $4.9 billion in the first year, $5.8 billion in the second year, and $6.4 billion in the fifth year with increased borrowing costs.

Rebecca Young, Director of Fiscal and Regional Economic Policy at Scotiabank, says the general rule is that a 0.25 percent increase in the Bank of Canada overnight rate reduces economic growth by about 0.1 percentage points. She says that reduced growth will quickly outweigh the higher interest rates as the primary driver of any deterioration in the government’s fiscal balance.