Title: Preparing for higher interest rates

Sub-title: Canadians have been profiting from extremely low borrowing costs. That won’t last forever.

 

Canadian borrowers have had it pretty good lately. Mortgage interest rates, already at historic lows at the start of the year, fell even further during January and February. The posted rate at CIBC for a five-year closed mortgage (which tracks that of other major Canadian banks) was just 5.39 percent this week, down from 6.55 percent in early January. Smart shoppers and hagglers can do even better.

 

As if that weren’t enough, financial institutions, taking their cue from the Bank of Canada’s low overnight rate, have kept interest rates low on a variety of other borrowing products ranging from consumer loans to some credit cards.

 

However according to one expert that may soon change.  “Earlier this year, we had forecast that the central bank would only begin to raise its policy rate in October,” said Francis Fong, an economist at TD Bank Financial Group. “However due to strong economic data, and the continued stickiness of core inflation we now believe that it will act as soon as July.”

 

Low borrowing costs matter

Interest rates matter because they are one of the most important influencers of Canadian economic activity. When consumers pay higher interest rates, they have less money available to buy new cars, television sets and restaurant meals. That in turn means that the businesses that produce and distribute those things all suffer. To put things in perspective: a one percent increase in the interest rate that Canadians pay on the approximately $1.3 trillion in household debt that they owe, would leave them with $13 billion less to spend each year.

 

Canadian federal and provincial governments too, which as Avery Shenfeld, chief economist at CIBC World Markets points out, have been running combined deficits of close to 10.0 percent of the country’s gross domestic product, are big beneficiaries from low borrowing costs.  For example in last week’s federal budget, finance minister Jim Flaherty announced that Canada would run a $49 billion deficit during 2010-11, following a $54 billion gap this year, much of which would have to be borrowed.

 

The country’s current ultra low interest rates date back to the wake of the economic crisis, when the Bank of Canada quickly brought its policy overnight rate, which influences many of the other of the country’s key rates, down to just 0.25 percent, or close to zero. The move, which echoed the policies of the US Federal Reserve Board, and those of many of the world’s other major central banks, is widely credited with having kept Canada out of a serious downturn, far worse anyway than the one we are just emerging from.

 

However the Bank of Canada’s drastic cuts to its policy rate turned out not to be enough. So last year, the central bank promised to keep it at near zero until the middle of this year. The hope was that consumers, knowing that they would not be hit with an abrupt rise in borrowing costs, would then have the certainty they needed to go out and spend.

 

The inflation problem

The good news is that the Bank of Canada’s boldness seems to have worked. During the fourth quarter of last year, Canada’s real gross domestic product grew at an impressive rate of 5.0 percent. Furthermore February employment data are expected to show that 20,000 jobs were created in the country that month. So if low interest rates are good for consumers, businesses and governments, why doesn’t the Bank of Canada always keep them at close to zero?

 

The reason is inflation. If interest rates are too low, for too long, then prices inevitably start to rise. If unchecked, inflation can get real bad.  One only has to look at the experiences of South American countries such as Argentina and Brazil during the 1980s for examples of how quickly inflation can spiral out of control when central banks keep interest rates too low for too long. For a more extreme example one only has to look at Zimbabwe today, one of the worlds poorest countries, which owes a good chunk of its most recent deterioration, to an inability to keep inflation under control.

 

The challenge for central bankers today is that once inflation gets into the system, it is terribly hard to get it out. The last time that happened in Canada was during the early 1980s and it caused a massive recession, and unemployment levels far higher than what we are seeing even today. As a result, most policy analysts expect that the Bank of Canada will begin to tighten its policy rate long before inflation starts to become a real problem.

 

The upshot is that as that Canadian consumers need to start preparing for a higher interest rate environment right now. At a minimum, that would imply not rashly borrowing to finance immediate consumption. The more ambitious could also start thinking about paying down some of that $1.3 trillion that households already owe.

 

Peter@peterdiekmeyer.com

 

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