Key Rate

What is the Key Rate?

In Canada, the key rate is the interest rate set by the Bank of Canada to regulate short-term borrowing between financial institutions. The key rate has been labeled under different titles over time, including the bank rate, policy interest rate, and target for the overnight rate. The equivalent of the key rate in the U.S. is the federal funds rate and the two-week repo rate in the U.K.

Uses of the Key Rate

1. Reserve Requirements

Because the key rate is the target rate of borrowing between financial institutions, it is also a significant component used in meeting the reserve requirement. The reserve requirement is a specified percentage of cash that financial institutions must keep on deck to meet liquidity needs, such as customer requests to withdraw funds. The reserve requirement is in place to mitigate insolvency. The key rate is used by financial institutions to borrow cash if they dip below the reserve requirement.

2. Monetary Policy

Another important aspect of the key rate is that it serves as the primary tool used by the central bank to carry out monetary policy. The key rate directly influences other interest rates used by consumers, such as credit card rates, personal loans, mortgage loans, and more.

Interest rates influence the economy through incentives for borrowing and saving. If interest rates are high, people have an incentive to save money. Conversely, if interest rates are low, people have an incentive to borrow and spend money. Because of this relationship, interest rates are used in monetary policy to shape the macroeconomy.

Inflation is another important consideration to monetary policy decision-making. A healthy inflation rate is around 2% annually. Anything drastically more will cause a reduction in purchasing power due to inflated prices and sticky wages. On the other hand, anything much less will cause stagnant economic growth – or in cases of deflation, it will cause a cycle of unemployment because deflation erodes business profits.

To keep inflation in check, monetary policy uses interest rates to influence consumer behavior and, therefore, the economy at large. When inflation is too high, the Bank of Canada will increase the key rate to incentivize saving (contractionary monetary policy). When inflation is too low, they will decrease the key rate to incentivize spending (expansionary monetary policy). The key rate can be used as an indication of current economic conditions, as well as future expectations.

Key Rate and the Bank of Canada

Since the Bank of Canada‘s establishment in 1935, the key rate has been slightly altered over time. At inception, the key rate was known as the bank rate and was a fixed rate set by the bank. Between 1935-1996, the key rate was changed between a floating rate and a fixed rate multiple times.

Beginning 1996 until the present, the bank rate slowly lost its importance as the bank shifted the key rate to the target of the overnight rate (or policy interest rate). This “new” key rate is a fixed rate set by the Bank of Canada on eight dates per year, situated around the midpoint of a 50 basis point operating band.

Because the Bank of Canada can only directly influence the key rate on eight dates a year, their alternative strategy is to indirectly influence it through treasury securities – this is known as open market operations under monetary policy.

For example, if the key rate shifts to the top of the operating band, the Canadian central bank can buy securities to increase money supply, which brings down the key rate. Vice versa, if the key rate shifts to the bottom of the band, it can sell securities to decrease money supply, bringing up the key rate.

Related Readings

CFI is the official provider of the Commercial Banking & Credit Analyst (CBCA)™ certification program, designed to transform anyone into a world-class financial analyst.

In order to help you become a world-class financial analyst and advance your career to your fullest potential, these additional resources will be very helpful:

• Bank Reserves
• Contractionary Monetary Policy
• Prime Rate
• Short-Term Debt
• See all commercial lending resources