Title: How low can interest rates go?
Sub-title: Lending rates are at historic lows, which is good for pretty much everyone...except savers. Inflation could also be a threat.
Canadian economic data, like those of many advanced western economies have been sluggish since the start of the year. Businesses have been shedding jobs, corporate profits are down and during the first quarter, the country`s GDP shrank by 8.5 percent on an annualized basis. Yet while politicians struggle with what to make of this, one bright spot shines out. Interest rates, which have been low for some time, have sunk to rock bottom.
“I have been in the business for ten years and I have never seen mortgage rates this cheap before,” said Ranjit Dhaliwal, a broker with Mortgage Intelligence Inc. “Despite the fact that house prices have more than held their own in many Canadian markets, borrowing costs have come down so far, that affordability has increased substantially.”
As a mortgage lender, Dhaliwal’s primary benchmarks are housing related borrowing costs. For example Mortgage Intelligence is currently offering a five-year fixed mortgage rate of just 3.99 percent, which is about of where mortgage rates were at the start of the decade. But they aren’t the only lending rates that have come down. Led by the Bank of Canada, which last month cut its overnight rate target to just ½ percent, borrowing costs on a wide range of products have fallen. Nor is Canada alone, U.S. mortgage rates have also dropped to a more than 50-year low.
The advantages of cheap money
However although almost everyone agrees, (especially lenders like Mortgage Intelligence’s Dhaliwal) that low interest rates are good for the economy, there are disadvantages. Economists say that lowering interest rates during a time of economic hardship can help turn things around. That`s because low borrowing costs encourage consumers to spend. This in turn creates jobs, because someone has to produce whatever those consumers buy. In the case of new housing for example, the economic spinoffs can be substantial, because when people buy new homes, they also tend to pick up a range of stuff, - like fridges, stoves and lawn maintenance contracts, - that come along with it.
Low borrowing costs also have a substantial positive effect on businesses. That`s because companies often rely on loans to finance new investments in plant, equipment and other forms of expansion. Even businesses that don’t expand can benefit from low rates. For example in the case of businesses running substantial lines of credit at their banks, during times of hardship the interest rates that they pay, often make the difference between whether they survive, or whether they go into bankruptcy, thus costing the economy a slew of jobs.
Even governments get a big kick when interest rates are low. The federal and provincial governments carry large amounts of debt. And while those levels have come down substantially as a percentage of GDP during the past decade, the borrowing costs that governments pay are no small thing. So when interest rates are low, they have a lot more cash left to spend on other stuff.
When interest rates are low, the economy also gets a push in one surprising and unexpected way: if people don’t earn a decent size return on their money when it sits around in a bank account, they are more likely to just go out and spend or invest it.
Savers and the inflation threat
The challenge of low interest rates is that while almost everybody instinctively likes them, they carry looming disadvantages, which are often not easy to recognize. The first problem is that low interest rates give a substantial hit to savers, particularly retired folk who live on fixed incomes. Investment experts often tell seniors not to keep too much money in stock markets, (which these days is a good thing), because they are too risky. As a result, seniors often have a big chunk of their savings tied up in fixed-income investments. And when the payouts on those savings fall, seniors get hit hard.
The other big threat is inflation. Because of Canada’s worsening jobs picture, almost no one talks too loudly about inflation right now. However the fact is that the way that governments keep interest rates low is by printing money. Both Canada and the United States have been flooding their economies with cash in a bid to pick them up. But when there is too much of anything around, its value tends to fall. In the case of money, that means more inflation.
How long can these low rates continue?
The big question right now is how long can the Bank of Canada’s cheap money policy continue? According to Sebastien Lavoie, an economist with Laurentian Bank Securities, the federal government and the Bank of Canada can hardly stand back and watch the current brisk implosion of economic activity.
Avery Shenfeld, chief economist at CIBC agrees. “The weak economic activity points to a move towards quantitative easing by the Bank of Canada in the first half and an extended period of very low short-term rates.” The bottom line is that despite the current rough economic times, those that have borrowing power, will be able to get some excellent deals for quite some time.
Peter Diekmeyer (Peter@peterdiekmeyer.com) is a Montreal based business and economics writer.
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