How a rate change reaches you: the transmission channels

A quarter-point, and where it goes

On a fixed announcement date the Bank raises its target by 25 basis points. Nothing happens to your mortgage that second. The change travels through four transmission channels, at four speeds, and its full effect on inflation takes 18 to 24 months.

1. Commercial interest rates. The chartered banks reset prime the same week, usually by exactly the 25 bp — prime moves one-for-one with the target. Anything priced off prime — variable-rate mortgages, lines of credit, floating business loans — moves with it. Other rates move less than one-for-one, because lenders' funding costs, competition and credit risk all enter too. Fixed mortgage rates do not follow the overnight rate at all directly: they follow Government of Canada bond yields of the matching term, which move on expectations of future policy (Lesson 8.7).

2. The exchange rate. Higher Canadian rates relative to other countries attract capital; the dollar firms within days — the fastest channel. A stronger dollar makes imports cheaper and exports dearer, both of which pull inflation down (Lesson 8.8).

3. Expectations. If households and firms believe the Bank will hit 2 %, they set wages and prices as if it will. A credible hike lowers expected inflation, which lowers actual inflation with no other mechanism required.

4. Asset prices. Higher rates lower the present value of every future cash flow, so bonds, shares and houses are worth less. Owners feel poorer and spend less.

Worked example — the bond that did not change

Halton Dairy Co-op holds a 3-year, 3 % annual-coupon bond with $1,000 par, bought at par when yields were 3 %. Yields rise to 4 %. The coupon is still $30 a year — it was fixed at issue — but a buyer can now get 4 % elsewhere, so the bond's price falls until its yield is 4 %:

=-PV(0.04,3,30,1000) → 972.25

At 3 % the same formula gives 1,000.00; at 5 %, 945.54. The direction is the whole of the asset-price channel: rates up, existing bond prices down, coupons unchanged. Module 10 builds the semi-annual version; here the point is the sign.

The order of arrival

Exchange rate (days) → prime and floating loans (the same week) → expectations (as fast as the announcement is believed) → asset prices and wealth (weeks to months) → spending and the output gap (quarters) → inflation (18–24 months). The Bank therefore sets policy for where the economy will be in two years, not where it is today — which is why it can look wrong in the short run and still be right.