Indebted homeowners and businesses, big-spending politicians and underemployed realtors all have June 5 circled on their calendars, hoping the Bank of Canada will finally start to roll back interest rates.
The first rate cut since the bank started its fight against inflation will be a turning point. But what matters more is how fast the central bank moves once it gets going, and how low interest rates will ultimately fall.
The answer: not as much as you might think. The cost of credit is, for a host of reasons, not returning to the comfortable levels prevailing since the 2008 financial crisis, never mind the rock-bottom interest rates during the pandemic.
Bank of Canada Governor Tiff Macklem put it bluntly in a House of Commons committee hearing last week: “Canadians should not be expecting that we go back to pre-COVID levels of interest rates and they shouldn’t be expecting a rapid decline in interest rates,” he told MPs.
That’s a fundamental shift for an economy fed on a rich diet of mortgage debt and deficit-financed government spending.
Still, there’s no question that interest rates will start coming down soon, perhaps as early as June. The Canadian economy is sputtering, and runaway inflation has almost been corralled. The case for keeping the central bank’s benchmark interest rate at 5 per cent, a two-decade high, grows weaker every month.
But there are limits to how quickly Mr. Macklem and his team can move. Their counterparts at the U.S. Federal Reserve are dealing with a much stronger economy and higher inflation. The Bank of Canada doesn’t have to be in perfect sync with the Fed. But it can’t get too far ahead without cratering the Canadian dollar, driving up the price of imports and reigniting inflation.
More fundamentally, there’s a growing conviction among central bankers that a host of structural economic and social factors will mean interest rates will generally be higher than in the recent past – that what economists call the “neutral rate” is drifting upward. (When a benchmark interest rate such as that of the Bank of Canada is neutral, it neither stimulates nor restrains the economy.)
For instance, Baby Boomers have mostly settled into retirement and are spending their nest eggs. That decreases the supply of savings in the economy. Globalization is headed into reverse. Decarbonizing the economy will soak up huge amounts of capital, increasing demand for loans. Such seismic shifts will exert upward pressure on interest rates.
The Bank of Canada formalized this thinking last month by raising its estimate for the neutral rate by a quarter percentage point to a range of 2.25 per cent to 3.25 per cent. By comparison, the highest the policy rate got in the decade before the pandemic was 1.75 per cent.
All this suggests that the Canadian economy is in for a long-delayed and much-needed adjustment.
Governments and households have gorged on cheap credit for decades. Household debt has ballooned from around 60 per cent of GDP in 2000 to more than 100 per cent today. Canada now has the highest level of household debt among G7 countries, and the fourth highest in the world, according to IMF data. And it has the grossly inflated housing prices to prove it.
Meanwhile, Ottawa and the provinces have funded their spending bonanzas with a growing mountain of debt, secure in the belief that interest rates would remain low, and debt charges would remain manageable.
This debt habit has come back to bite Canadians over the past two years. Mortgage payments skyrocketed. Public debt charges surged, particularly among the provinces.
The federal government paid $20-billion to service its debt in 2020, when interest rates were at rock-bottom. By last year, that had risen to $47-billion, and it’s expected to hit $64-billion in 2028 – more than the Canada Health Transfer that Ottawa will send to the provinces.
Roughly half of all Canadians with mortgages have seen their payments increase since the bank started raising rates in 2022. The rest will see their mortgages reset over the next two years, and most are in for a painful payment shock, the Bank of Canada warned on Thursday in its annual Financial Stability Report.
In a world of more costly money, public and private debt will pinch harder. Borrowers beware.