How Central Banks Shape the Economy — And Impact Your Finances

Central banks, such as the Bank of Canada or the Federal Reserve in the United States, wield enormous power. 

They’re not your everyday banks: You can’t pop in to stash your cash, there are no branded ATMs, and no welcoming reception areas await customers. Instead, central banks manage the supply of money to help manage inflation while strengthening the economy. 

Their decisions can affect various aspects of your financial life, from mortgage costs to interest on your savings account and your portfolio performance. Here’s a primer on the inner workings of central banks—and how they may affect your finances.

What do central banks do?

At a high level, central banks manage the monetary system for their respective countries. The Bank of Canada, for example, designs and issues our currency, the Canadian Dollar (CAD), which is then either manufactured by the Canadian Mint (for coins) or printed by Canadian Bank Note Company (for bills). It also monitors currency already in circulation.

Today, central banks also play a pivotal role in moderating the economy. Central banks have the power to set the overnight lending rate, for example, which impacts each financial institution’s prime interest rate. And they also implement policies that control inflation and aim to keep the value of the CAD stable relative to other currencies.  

Interest rate moves: From 2020 to now

Central banks are best known for setting interest rates, which affect the broader economy and your investing strategies. As recently as early 2020, most Western central banks kept rates close to zero, which was meant to make borrowing easy and inexpensive.

Then supply-chain snarls and a host of other pandemic shocks led to eye-popping increases in the cost of living, also called inflation, in many advanced economies, including here in Canada.

In response, the Bank of Canada lifted interest rates seven times in 2022, followed by three modest bumps in 2023. Overall, this raised Canada’s overnight rate from 0.25% to 5% in a span of just two years. Borrowing costs for Canadians jumped—particularly homeowners with variable rate mortgages, whose rates rose along with the overnight lending rate. 

In 2024, however, rates have begun to drop. The Bank of Canada implemented three 0.25% cuts in June, July, and September.

Spotlight on inflation

Central banks play another key role in managing the economy: They’re responsible for controlling inflation. In Canada, The Bank of Canada aims to keep inflation at roughly 2%—the midpoint of its target range of 1 to 3 percent.

When inflation is high, central banks try to curtail consumer spending by raising interest rates—and therefore borrowing costs. Conversely, central banks attempt to spur economic activity by lowering rates, making credit more plentiful.

With interest rate decisions, central banks are hoping for a “soft landing,” an industry term for slowing an economy without a severe economic downturn and heavy job losses. 

How rate fluctuations impact Canadians

Changes to the interest rate can have wide implications on your finances. Here’s what generally happens when rates change:

1. Borrowing costs fluctuate.

Interest rate fluctuations can also significantly impact Canadians’ debts, including credit debts and mortgages. When rates go down, consumers can typically access credit at a more favorable rate. 

When rates decrease, you’ll generally be able to get a fixed rate mortgage at a lower rate, though rate changes do not impact existing fixed rate loans. And, if you have a variable rate mortgage, paying a lower interest rate means more of each payment applies to the principal on your home, speeding debt repayment.

Similarly, if you have a personal loan with a variable interest rate, you may see a decrease in your monthly payment.

2. Inflation rises and falls.

Interest rates may have an inverse relationship with inflation: When rates go down, inflation generally increases, and vice versa. As a result, you may feel the impact of lower interest rates on your budget in the form of higher prices. 

3. You’ll earn more—or less—interest on your savings.

Changes in the overnight rate also affect the interest earned on savings and guaranteed investment certificates (GICs). Generally, the higher the overnight rate, the more interest you’ll earn on your savings. Conversely, when rates drop, the amount of interest you’ll earn from your savings account, or when opening a new GIC, will go down.

4. The performance of your portfolio may change.

Interest rates also influence the stock market. In general, the stock market reacts favorably to rate cuts, so you may see a boost in your portfolio when rates go down. However, the impact of interest rates on the market is complex, and the impact on your portfolio depends on your holdings and investment strategy. 

Amid rate fluctuations, it can be tempting to adjust your portfolio to adapt to the economy. However, short-term market volatility may not impact your long-term goals. It’s a good idea to connect with your advisor to discuss any concerns you may have, and work together to ensure your investment strategy supports your goals. 

Monetary tools go beyond interest rates

In addition to interest rates, central banks have other tools at their disposal to ensure financial and economic stability.

One popular tool is the reserve requirement ratio, which determines how much commercial banks can loan to customers. A lower ratio means that financial institutions can lend more, which can in turn fuel economic growth. Central banks can also buy open market securities (typically longer-term government bonds) to increase the amount of cash in the economy. The maneuver is called quantitative easing, a relatively new form of monetary policy.

In the past decade, an era of “easy money” partly fueled an economic boom, economists say, lifting the fortunes of companies and consumers. When credit is plentiful, companies tend to ramp up hiring and production. It also buoys the stock markets and pushes up asset prices.

Central banks aren’t immune to losses

Monetary policy influences more than company bottom lines and people’s pocketbooks. Central banks themselves can also feel the squeeze of rising interest rates. That’s because a central bank’s balance sheet holds a number of assets (say, bond-buying revenue and investments) as well as liabilities (like the cost of paying interest on deposits from the country’s financial institutions).

Typically, a central bank’s assets should exceed its liabilities, with profits distributed to the government. But when interest rates rise, so does the amount a central bank owes its creditors—and when that column exceeds its assets, a bank may start to actually lose money.

In 2022, the Bank of Canada recorded its first loss in its 87-year history, $522 million in the third quarter. However, these losses won’t interfere with the bank’s ability to carry out monetary policy. 

Align your portfolio with your goals in a changing economy

As investors, it’s helpful to understand that the decisions central bankers make have ripple effects that can play out on your purchasing power, your job prospects and your financial wellbeing.

To learn more about how the central bank’s decisions may affect your finances, and discuss how the economy may impact your investment goals, connect with your advisor.

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