Where are interest rates going?

Hey there, time traveller!
This article was published 16/06/2023 (1021 days ago), so information in it may no longer be current.

The Bank of Canada abruptly changed course this month and raised its policy interest rate to 4.75 per cent. The course change can be expected to set off an increase in mortgage rates from current five-year levels around 6.5 per cent. It has also invigorated concerns about the affordability of housing.

The rationale from the Bank of Canada is that underlying inflation remains stubbornly high and economic growth remains stubbornly strong despite the series of rate increases over the past year.

When I came to Winnipeg in 1979 to teach at the University of Manitoba, the bank rate was at 12 per cent and we were fortunate to find a suitable starter home with a mortgage rate in the same range. While that seems high by current standards, the context included inflation running at 9.3 per cent annually, implying a real interest rate of around 2.7 per cent. The current inflation rate of 4.4 per cent implies a real policy rate of 0.35 per cent and real mortgage rates around 2.1 per cent, not too far off the real mortgage rate in 1979.

High inflation rates were embedded in the economy by 1979. Our first mortgage taxed our resources, but inflation carried over into wage settlements to provide some relief until renewal time. And a fixed five-year mortgage protected us from even higher inflation, which peaked at 12.5 per cent in 1981 as interest rates skyrocketed to 18 per cent! Unfortunately, mortgage renewals in 1984 and 1989 provided little relief, as interest rates only moderated to the 12-13 per cent range.

By 1994, inflation had responded, falling to the two per cent range, which had then become the announced Bank of Canada target. Mortgage rates remained high at 9.5 per cent, or about 7.5 per cent in real terms, but would fall steadily. My renewals in 1999 and 2004 at 7.5 per cent and 6.2 per cent were much closer to the territory we now occupy but higher in real terms because inflation was near its target and not the 4.4 per cent we have today.

Then along came the financial crisis of 2008-9 and the pandemic of 2020-2, both of which produced widescale disruption to demand and employment. In both cases, interest rates were lowered sharply and other financial measures were taken to ease credit, restore demand and moderate the economic impact in a fashion learned from previous recessions. The Bank of Canada policy rate was reduced to 0.25 per cent in 2009 and five-year fixed mortgage rates fell to historically low rates.

By 2019, mortgage rates fell again below five per cent, leading to an explosion in housing demand among those largely unaffected economically by the pandemic despite efforts to dampen demand by introducing stiffer mortgage stress tests.

Concerns about housing affordability need to be read in a spatial context. Ownership rates in Canada have been high by historical standards for a very long time but were already falling before the pandemic, primarily in rapidly growing and larger urban centres such as Toronto and Vancouver. Lower interest rates stimulated demand and prices in these and other hot real estate markets, with much smaller effects in modestly growing cities like Winnipeg.

Although the low interest rate environment that began in 2008 had really settled in by 2022, one stimulus to housing demand for those who could afford it was the common perception that interest rates would rise as the Bank of Canada sought to restore demand to more normal levels. What was not anticipated was the extent to which supply management, coupled with the unanticipated war in Ukraine, would strengthen inflationary pressures as economies around the world normalized.

Modern monetary policy, with its emphasis on interest rate management, reacted in the expected fashion but inflation has proven to be a more difficult problem than expected. While rising interest rates worsen affordability in the short term, it is difficult to see a better alternative. Keeping interest rates lower would provide some short term relief but would not appear to apply sufficient brakes to spending to bring inflation down to the two per cent target.

My job before Winnipeg was at the Economic Council of Canada’s Centre for the Study of Inflation and Productivity, which was established after the termination of mandatory controls on prices and incomes in 1978. With inflation still at nine per cent in 1978 and showing no signs of abating, it is safe to say that the era of mandatory wage and price controls from 1975 had been a failure. What was left beyond monitoring and studying the problem was stringent monetary and fiscal policy and painfully high interest rates.

By that experience, today’s interest rate increases seem sensible and measured. Affordability means lowering inflation and keeping it stable, and that remains the responsibility of an independent Bank of Canada.

Where are interest rates going? As inflation moderates to the two per cent target, past evidence suggests that the real policy rate could settle at about 0.5 per cent, or a nominal policy rate of 2.5 per cent. That policy rate with two per cent and stable inflation in 2004 generated five-year mortgage rates in the vicinity of six per cent, about where they are now. Thus, as monetary policy grinds toward the two per cent inflation target, perhaps with some further increases in interest rates, homeowners and buyers should not expect mortgage rates to fall much beyond where they are now in the end, barring another unforeseen calamity. But we have had enough economic misfortune for a while, as far as I am concerned.

Wayne Simpson is a professor of economics at theUniversity of Manitoba and a research fellow, School of Public Policy, University of Calgary.