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by Mark Jasayko and Neil McIver
The Vancouver Sun
Interest rate policy is often divisive, pitting borrowers against savers and investors against speculators.
On Tuesday, the Bank of Canada raised its key lending rate from 0.50 per cent to 0.75 per cent. On balance, this rate increase will be good for Canada, whose economy has reached a level that is the envy of others, judging by the accolades received in the international press.
However, using low rates to stimulate our economy towards an even higher trajectory could create imbalances that will eventually risk our new global economic standing.
To some, such as politicians, speculators and profligate consumers, a juiced-up economy sounds like a fantastic proposition. Unfortunately, most Canadians don’t fall into any of these categories. If interest rates are kept too low for too long, economic resources begin to flow rapidly to relatively unproductive uses. In the end, disasters such as real estate bubbles pose the greatest risk.
We only have to look south to see what an era of “easy money” interest rate policies have achieved: a real estate meltdown and an economy that has remained flat for a decade when the effects of financial engineering and over-borrowing are netted out. Apart from some lucky real estate speculators who timed things perfectly, is the U.S. better off?
Higher rates would have played an important role in bringing balance to the U.S. economy. Instead, there were some stunning side effects of low rates that included the statistic that 40 per cent of all job creation was related in some way to real estate (agents, bankers, mortgage brokers, construction firms, etc.) before the bubble burst.
Higher rates would have helped other service and manufacturing industries to compete for the labour that was otherwise attracted to real estate with its fevered speculation and promises of unending growth.
In a concerning development, real estate prices in Canada are back at record levels and in many cities prices exceed afford-ability indices. If the bank rate is kept too low for much longer, Canada risks the potential of becoming an economy that is too dependent on maintaining real estate price trends, inhibiting our ability to grow beyond the currently hot economic industries of construction and resources. The future of our economy will be on more solid ground with more diversification and job growth in other areas, and interest rate policy will have an effect on this.
Another benefit of higher rates is to provide savers with a yield. Recently, savings rates in Canada have plummeted as Canadians are being induced to borrow and spend while employment remains strong and rates remain low. In addition, there is reduced incentive to save and invest when yields are so low.
Even worse, for those who are saving or who depend on current investment income, there is the temptation to invest in lower quality investments in order to pick up a little more yield.
The asset-backed commercial paper catastrophe illustrated the hazards of this strategy for income-seeking investors who did not have the resources to assess the true underlying quality.
Finally, being able to cut rates in a time of crisis is crucial. However, this tool is drastically compromised when rates are already severely low, tantamount to “pushing on a string.” If the anemic global economy begins to impact Canada through trade flows, we are going to need all the policy ammunition we can muster.
Increased rates now will ensure that we are able to fight that battle if it arrives, thereby protecting our newly acquired, and envied, economic advantages.
Mark Jasayko and Neil McIver are portfolios managers with McIver Wealth Management Consulting Group at Richardson GMP Ltd.
Forecasting Interest Rates
Boyd Erman
Globe and Mail Update
After a year of making it easy by telling the market exactly what the Bank of Canada would do with borrowing costs by giving a commitment to keep them at emergency lows, Governor Mark Carney has rapidly switched tacks. The country’s top central banker is now confounding those who would try to predict exactly how fast interest rates will rise by refusing to give explicit guidance.
Yesterday’s quarter-point increase in the benchmark central bank rate and the accompanying statement show that the kind of transparency markets get from Mr. Carney as borrowing costs go up in coming months is going to be very different than what they have become used to over the first part of his tenure, when rates dropped to record lows and stayed there.
In this statement, Mr. Carney is being open but not predictable. He is laying out the parameters he is watching and leaving it to markets to try to figure out what that will mean for rates. It’s an education for investors and analysts, because this is the first time they have seen Mr. Carney raising borrowing costs.
“It’s going to be more fun being the central banker in this environment than being a forecaster,” said Mark Chandler, a rates strategist at RBC Dominion Securities who predicts “a whole bunch of angst” before every Bank of Canada rate announcement in coming months.
Just as the explicit commitment to keep rates low served a purpose by giving an uncertain economy some certainty, the new move to the other end of the predictability spectrum gives Mr. Carney the flexibility he needs to deal with a stop-and-go rebound in growth.
The economy posts a couple of hot quarters and inflation ticks up? Fine, a quarter point tighter it is. But then we wait and see.
This isn’t a normal recovery, so there’s no sign of the central bank’s normal language in a tightening cycle. Usually, there is wording foreshadowing a steady move higher, along the lines of “some further reduction of monetary stimulus will be required,” to quote a 2005 rate hike announcement. This time, the guidance is that “any further reduction of monetary stimulus would have to be weighed carefully against domestic and global economic developments.”
With that, Mr. Carney has established himself as neither hawk nor dove, just a pragmatist who watches the data and the markets and reacts.
Already, there are signs that the new strategy is a success. The market is re-evaluating its belief that more rate cuts are a sure thing.
Read more at:
www.theglobeandmail.com
More about forecasting interest rates:
Economists use a variety of techniques to forecast interest rates. The most basic is to use economics and history as a guide and to make a judgement about what an appropriate level of interest rates and their future course given the state of the economy and important economic variables. Since most economists disagree on how the economy works or what economic history means, this is more difficult than it seems.
See Schools of Economic Thought.
Quantitative economic statistical techniques called “econometrics” attempts to model the economy using mathematical and statistical relationships. A comprehensive model of the economy might have hundreds of equations and many variables. The problem with these techniques is that while they might have a “high explanatory power” or be “robust” historically against “back-tested” data after the fact, they are very poor at explaining the future before the fact.
See Econometric Techniques.
The reason for this inaccuracy is simple. Interest rates reflect human behaviour which is highly complex. This complexity has been compounded by the internationalization of economies and the financial markets. The direction of Canadian and U.S. interest rates is partially set by those of other countries, particularly Germany and Japan. Even governments miss their interest rate forecasts and they have control over their countries’ monetary and fiscal policy.
The effect of rising Interest Rates on Real Estate
National Bank of Canada worries that the impact of rising interest rates on the residential housing sector “could be dire” in Canada.
According to economists Matthieu Arseneau and Yanick Desnoyers,
“Though the Bank of Canada has done well to set its rate normalization process in motion, the fact remains that the stakes at play are high, with home prices and household debt at record levels relative to income, … The residential real estate sector, which is extremely sensitive to interest rate fluctuations, could have the wind knocked out of its sails if interest rates do nothing more than normalize.”
The two economists studied previous periods of rising rates, given that the Bank of Canada last week began hiking its benchmark overnight rate from the emergency low it used to fight the recession. The fall in rates increased the borrowing capacity of Canadian families, they said, in turn helping to drive home prices to levels that, as a percentage of personal disposable income, have never been higher.
“Whereas a 100-basis-points increase would have meant an extra $101 in 1994, the same hike would amount instead to $177 today,” they said, looking at the impact on a three-year mortgage. “… In order to take into account the fact that household ability to pay has changed over time, we represented this amount as a [percentage] of the income of a two-parent double-income with children family. Accordingly, the impact of a 100-basis-points increase in the three-year rate on monthly mortgage payments is 18 per cent higher today than it would have been in 2004 and 14 per cent higher than it would have been in 1994.”
Meanwhile the Canadian Real Estate Association is now saying that 2010 sales will not be as strong as previously forecast. Nonetheless CREA expects 490,600 sales through the Multiple Listing Service in 2010, a 5.5% jump from a year earlier and the second-best year on record.
“With interest rates soon expected to rise, Canada is widely believed to be entering a typical demand-driven downturn due to recent prices increases and rising interest rates,” said Gregory Klump, chief economist with CREA. “A downward trend in national sales activity combined with an increase in listings will result in a more balanced market. In keeping with the return of a balanced housing market and typical demand-driven housing market cycle dynamics, prices will remain stable.”
Mr. Klump emphasized that Canada’s mortgage market remains “solid,” and that conservative lending practices mean the country will not experience the same type of correction the United States has had where prices have fallen as much as 50% in some markets.
Last month, CREA issued a report debunking the theory put forward by a number of commentators that the Canadian housing market was headed for a major correction. The report came on the heels of an analysis from Canadian Imperial Bank of Commerce senior economist Benjamin Tal that housing prices in Canada were 14% overvalued.
Carney’s big call
Paul Vieira,
Financial Post
Bank of Canada governor Mark Carney has had a busy time of it since taking over as the country’s central banker 27 months ago, mostly tackling the financial crisis, mapping out the road to recovery and reassuring Canadians that at the end of the day the bank’s extraordinary policies would work.
The one thing he has yet to do during his term, however, is raise interest rates. That might be about to change on Tuesday. If he does pull the trigger – and that is what most analysts expect – it won’t be after grappling with competing forces that convey two starkly different messages about the economic outlook.
“We are at point where it is a tug of war between structural issues that are facing the eurozone and a very strong economic cyclical backdrop,” says Stéfane Marion, chief economist at National Bank Financial.
Weighing on the governor are the economic data, which call out for a rate hike – as much as 50 basis points, some reckon. The data have been consistently strong and surprising to the upside. Job creation is in full swing, with a record 109,000 workers added to payrolls in April; consumers are buying up goods at a healthy pace, tax credits or not; corporate profits are rebounding to pre-recession levels; and inflation is creeping closer to the central bank’s preferred 2% target. The sterling fundamentals prompted the central bank last month to ditch its conditional commitment to keep its policy rate at a record low 0.25% until July, leading traders to price in a nearly 100% chance of a rate hike on June 1.
That was until sovereign debt worries exploded in Europe, once Greece formally asked for international help days after the last Bank of Canada rate decision. That sparked an across-the-board retreat in global equity markets, down 9.3% since the beginning of May, as traders sold stocks and poured into risk-averse U.S. treasuries and other government securities on fears that another credit crunch was at hand. Mr. Carney is likely aware of this better than most, given his capital markets background from Goldman Sachs.
The most worrying sign on Mr. Carney’s radar screen might be the small but steady increases in the cost of borrowing among banks, a signal European lenders are finding it tough to access cash from their peers on concern over how much Greek, Portuguese and Spanish debt they hold.
In the end, the consensus is Mr. Carney is leaning toward a rate hike – a modest one, though, of 25 basis points. The thinking is, an ounce of prevention now is worth a pound of cure later.
“We can’t look at things in a vacuum, because there are so many other factors besides Europe’s issues” says Jonathan Basile, an economist with Credit Suisse in New York who closely watches Canadian markets. “The truth is the macroeconomic evidence is outweighing the financial risks right now.”
The last time the Bank of Canada raised its benchmark rate was in July 2007, by 25 basis points to 4.5%. At the time, former governor David Dodge said the economy was operating above its production potential, and inflation was likely to stay above its 2% inflation target for longer than forecast.
Little did Mr. Dodge know that the U.S. subprime crisis would morph into the worst financial crisis since the Great Depression, roiling markets and economies around the world. This is why Europe’s recent fiscal woes have triggered a case of nerves, and might prompt Mr. Carney to rethink any rate move.
“The Bank of Canada wants to raise rates, but it doesn’t have a crystal ball,” CIBC World Markets said in a note to clients. “It can’t be certain that the recent financial market downturn isn’t going to morph into something more severe that would make a rate hike look out of place.”
There’s another school of thought, though, that suggests markets have overreacted to a regional problem. In this context, it is key to remember the Bank of Canada didn’t expect the eurozone to contribute much to global growth, envisaging only 1.2% expansion this year and 1.6% in 2011.
“The European picture will calm down and people will realize it is not as dramatic as being played out,” says Carlos Leitao, chief economist at Laurentian Bank Securities.
Yes, he acknowledges, the debt-ridden southern European economies have tough years ahead. But other countries, led by Germany and France, are going to capitalize on the lower euro and boost their exports to emerging economies and North America, which will help offset the drag from the so-called Club Med nations.
Besides Europe, Mr. Carney has other factors to consider.
Canada’s sovereign debt levels are indeed much better than the industrialized world, as our politicians like to remind us. But the amount of debt held by households, measured as a percentage of disposable income, stood at a historical high of 146% – of which 98% is mortgage related – at the end of 2009, rating agency DBRS estimates. That would put Canadian households ahead of the United States but behind Britain on this measure. A rate hike would signal it might be time to live more modestly and refrain from too much debt-financed consumption (which helped fuel those nasty asset bubbles that central banks may want to pay more attention to in the aftermath of the subprime debacle).
Mr. Carney’s other challenge is to explain why, and what’s ahead. He has come off a period where he provided extraordinary guidance to markets. Don’t expect similar language from the governor.
If anything, Mr. Marion warns the central bank should refrain from using the type of guidance the U.S. Federal Reserve deployed in 2004, when it signalled a period of “moderate” rate hikes were in the offing.
In retrospect, the Fed’s use of the word moderate “encouraged more financial excesses,” leading to the subprime bust, Mr. Marion says. “Carney doesn’t have to be brusque about it. He has the luxury to start slowly, and leave his options open,” from pausing should Europe deteriorate to hiking aggressively, by 50 basis points, if conditions warrant.
Mr. Carney reminded us recently that “nothing is pre-ordained” at the Bank of Canada. He’s likely to drive home that point on Tuesday, rate hike or not.