In response to the COVID-19 pandemic, the Bank of Canada and government crown corporations are taking extraordinary measures to ensure the Canadian financial system continues to operate.
Under normal circumstances, the Bank of Canada’s mandate is to maintain the inflation rate between 1 and 3%. The primary tool it uses to achieve this goal is setting a target for what is referred to as the “overnight lending rate.”
The overnight lending rate is the rate at which banks and other financial institutions lend money to one another, to cover all their day-to-day operations. When the Bank of Canada makes its regularly scheduled bank rate announcements regarding the target for the overnight lending rate, they are setting the mid-point of a band. As of April 17, 2020, the Bank of Canada’s target rate is 0.25%, with an upper bound of 0.75% and a lower bound of 0.25%. The Bank of Canada tracks agreed-upon interest rates among financial institutions. If the rates drift too high, the Bank of Canada offers to lend money, if the rates fall too low, they borrow at the target rate. These actions ensure overnight lending contracts stay within the Bank of Canada’s prescribed operating band.
By lowering the target rate, as the Bank of Canada did on March 4, and again during emergency announcements on March 16 and March 27, it reduces the rate financial institutions are lending to each other and receiving funding. The lower interest rate usually allows financial institutions to lower the interest rates on loans to consumers and businesses.
As of March 27, the Bank of Canada lowered the target for the overnight lending rate to 0.25%, which it believes is the effective lower bound for the overnight lending rate. Meaning it will not lower interest rates below this threshold. While other central banks, including The European Central Bank, Switzerland, Demark, and Sweden, have implemented negative interest rates, the Bank of Canada believes that negative interest rates are likely to constrain the proper functioning of monetary policy. The Bank of Canada has instead opted to provide further stimulus through large scale asset purchases (also known as quantitative easing).
The aim of these purchases is two-fold. The first is to increase the amount of cash available to financial institutions for lending purposes. The second is to play the role of market maker/buyer of last resort.
In the role of market maker, the Bank of Canada ensures owners of all these types of assets can find a buyer who can pay them in cash if the owner needs cash to pay bills, invest in new developments, or pay staff. By announcing its intention to buy these assets, the Bank of Canada ensures others are also willing to trade in them since market participants know they have a buyer of last resort.
The Bank of Canada is intervening to support markets for federal government debt, provincial government debt, corporate debt, and mortgage debt. These interventions vary according to the level of support the Bank has deemed each market requires.
The details of these asset purchases are available through the Bank of Canada’s website.
As further support to mortgage lending at this time, Canada’s Minister of Finance, Bill Morneau, announced the Insured Mortgage Purchase Program. Through this program, CMHC would purchase up to $5 billion in mortgages in March, and $10 billion per month in at least the following three months.
CMHC is only purchasing mortgages it has already insured, in order not to take on additional risk. CMHC also announced it would provide insurance on mortgages with low loan-to-value ratios (mortgages with more than a 20% down payment) with amortizations up to 30 years as well as refinanced loans, as long as those mortgages had already been funded before March 20, 2020. The limit of having been funded before March 20 was put in place to make sure CMHC is not encouraging new mortgages or sales activity during the pandemic.
The expansion of mortgage insurance to these additional mortgages allows financial institutions to purchase mortgage insurance on previously uninsured mortgages. Once insured, those loans will be eligible to be bought by CMHC, as they would have the backing of the government. These steps broaden the pool of low-risk assets available for the Bank of Canada and CMHC to buy, to get money into the hands of financial institutions.
The combined effects of these open market operations on mortgage and housing markets are to keep financial markets functioning correctly and lower the cost of borrowing for businesses and consumers. The decrease in lending rates is supportive for consumers getting into the market once containment measures ease, and Canadians can get back to a more normal way of buying and selling homes.
For more CREA Stats information, visit creastats.crea.ca.