Title: Is the BOC set to hike interest rates?

Sub-title: After keeping its key rate near zero for more than a year, the central bank looks ready to tighten.

 

In recent weeks, housing sector stakeholders have been wondering if the Bank of Canada will hike its policy interest rate on its next announcement date, scheduled for June 1rst. Canadian economic data, including retail sales, job creation and housing sector activity have all been strong, indicating that an economic recovery is in progress. However if the central bank keeps interest rates too low, too long, inflation may rear its ugly head. As a result, the Bank of Canada is widely expected to act either this month or the next.

 

In either case, a hike in its policy rate would represent a major policy shift. To reassure financial markets following the financial and economic crises, during the fall of 2007, Canada’s central bank quickly cut its key lending rate from near 5.0 percent, to just  0.25%. The Bank of Canada’s policy rate has a major influence on borrowing costs, which in turn affect almost all key economic sectors. As a result, by keeping rates low, Canada’s central bank almost certainly kept the country out of a major economic slowdown.

 

Now the Bank of Canada has to worry about fulfilling the second part of its mandate, which is to make sure that rising goods and services prices don’t get out of hand. During March, core inflation rose to 1.9 percent, close to the middle of its 1% to 3% target range. To ensure that things don’t get out of hand, in April, the central bank signaled that low rates would not last forever, by abandoning its commitment to keep its policy rate near zero, though it did not specify, when or how it would act.  

 

Increased pressure

Increases in the Bank of Canada’s policy interest rate will almost certainly put pressure on Canada’s ever-hot housing market, says Hélène Bégin, an economist at Desjardins Group. Buyers are already reeling under the pressure of mortgage rates, which, have climbed noticeably higher since their mid-March lows, and tighter federal government rules for those who want to obtain mortgage insurance.

 

“The substantial upswing by bond markets early in the year, pushed up financial institutions’ costs of funds,” explains Bégin. “As a result, the honeymoon seems to be over.” During the past week, both Desjardins Group and RBC Economic Research released reports that showed housing affordability has already started to fall throughout the country, with the notable exception of Alberta.

 

In fact rising mortgage costs are already starting to put a damper on things. Although the Canada Mortgage Housing Corporation reports that housing starts on a seasonally adjusted basis rose to 201,700 units during April, up from 199,200 units in March, this pace is unlikely to continue. The federal mortgage insurance agency expects that starts will slow to 182,000 units for the year as a whole, and to 179,600 units next year, levels that are more in line with longer term Canadian demographic growth and economic fundamentals. Canadian Real Estate Association data also show signs of slowness. Existing home sales, while still strong, have leveled off from previous peaks, and inventories of unsold homes are building up.

 

What’s happening in the US and Europe

That said, in today’s interconnected global economy, the Bank of Canada’s interest rate policy decisions are no longer solely based on what happens here. A huge chunk of Canadian exports, investments and jobs are heavily dependent on what is happening in the United States, and Europe. According to Sébastien Lavoie, an economist with Laurentian Bank Securities, not much of the news there is good, though he believes that a rate hike is nevertheless inevitable.

 

Although the United States has apparently returned to economic recovery and recent consumer confidence numbers have been strong, core data has been anything but. Job creation numbers have been week, salary growth has been non-existent, and credit continues to be exceedingly tight, all of which are stifling demand.

 

Europe for its part appears to be locked in a credit crisis fueled by fears that many of its member debtor nations will not be able to meet their obligations as they become due. “Domestic considerations overall are vigorous enough to push the Bank of Canada to increase its policy rate by 50 basis points on June 1rst,” wrote Lavoie, in a recent note to the bank’s clients. “That said with tensions in Europe, a 25 basis point hike is more likely.”

 

Bégin too believes that tighter money is in the cards. In fact Desjardins Group’s internal projections show that five-year closed posted mortgage rates at the major banks, which are currently just under 6.00% could rise to 7.85 percent by 2014.

 

If that is true, then it will be a long time before consumers will be able to borrow as cheaply as they can today.

 

 

Peter Diekmeyer (peter@peterdiekmeyer.com) is a Montreal-based freelance business writer.

 

 

 

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