They are the main tool that central banks – like the Bank of Canada – can use to keep economic activity at a level they consider to be viable.  

When the economy starts overheating and prices rise too quickly, the Bank raises its rates to make borrowing more costly, and saving more attractive. Consumers and businesses then reduce their spending, and economic activity slows down. Conversely, if the economy seems too sluggish the Bank will lower its rates. 

A rate increase has a number of consequences. First, all new borrowing, such as a mortgage, line of credit or car loan, becomes more expensive to repay. Similarly, any overdue amount you may have outstanding, such as an income tax balance, could incur higher interest charges. 

In your investment portfolio, the market value of existing bonds might drop, since new ones will be issued at a better interest rate. Stocks also tend to suffer due to the anticipated economic slowdown. On the other hand, this is a time when new opportunities may come up, and when a healthy degree of portfolio diversification can be of great benefit.  

Because all these trends actually reverse when the markets are anticipating a drop in interest rates. When rates go back down, the cost of borrowing eases and saving becomes less desirable. Consumers and businesses increase their spending and investing. And economic growth picks up… until the central banks think it’s time to slow things down again.