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Canadians can barely remember the last time rates were this high, but get used to it. Bank of Canada (BoC) deputy governor Paul Beaudry, speaking a day after the rate hike, warned the era of low interest rates is over. They justified the forecast with a slate of reasons that didn’t quite make sense, and will reverse based on a gut feeling. Uh, sure.
Real, Negative, and Neutral Interest Rates
Understanding the deputy governor’s speech requires understanding three terms. The first is the real rate of interest, which is the inflation adjusted rate. It’s just subtracting the rate of inflation from the interest rate. For example, if you took out a mortgage with a 2% interest rate while inflation was 5%, it would have a -3% interest rate.
That brings us to the next one, negative real interest rates—when it falls below 0%. Borrowing money is effectively cheaper than holding cash, since inflation erodes the loan. Central banks use negative real rates to drive demand, in an attempt to raise inflation. Hopefully they don’t underestimate inflation when taking this one on.
The third term is neutral policy rate—the rate where inflation and interest are in harmony. It’s a unicorn that central banks chase, where inflation is at target, and interest rates don’t provide stimulus or become restrictive on borrowing. Everyone has a job, the cost of goods is stable, and the streets are made of rainbows.
An important side note on the last one is that Canada doesn’t have its own neutral policy rate. It uses the US neutral rate estimate, which seems wreckless for a sovereign issuer of a convertible currency. It might not be clear, but the US is a very different economy with a different need for credit stimulus. The wild and irrational decision to use the US rate contributes to overstimulated Canadians with some of the highest debt loads in the world.
Long-Term Real Rates Have Been Declining In Advanced Economies
Canada has seen interest rates go down, but until recently they refused to go back up. Deputy governor Beaudry explained that rates have generally been falling across advanced economies, then used some shaky logic to justify the trend. Four key points:
- Higher savings rates as populations age.
The central bank explained that older households will save more, implying that lower rates are needed to motivate use.
It’s a chicken and egg situation though, since low rates helped push the average cost of shelter from 17% of household income, to 30% these days. Since the cost of shelter is closely linked to birth rates, perpetually falling interest rates helped drive an aging population in advanced economies.
- China & Other High Savings Economies Joined The Global Economy
China “and other developing countries” with higher savings rates have joined the global economy. The central bank cited the influx of global capital these households are providing has applied downward pressure on rates.
Fun fact: The term developing country isn’t defined, and is self declared at the World Trade Organization (WTO). Under WTO rules, a developing country gets special provisions for implementing agreed commitments and measures to increase trade. That fact gets more fun the longer you think about it.
- Rising Inequality
Rising inequality has also been a factor, according to the BoC. They explained that wealthier households tend to save more, creating further downward pressure on real rates.
Researchers from the Dutch Central bank found that low rates funnel money to the rich. Low rates provide leverage and inflate assets, allowing those with the most assets to capture more of a country’s economy. The BoC also found low rates inflated home prices, furthering inequality as well. But sure, it’s the inequality driving rates lower.
- Fewer Attractive Investment Opportunities
The final major pressure the BoC cited was “the investment puzzle,” or falling productive investment. It’s puzzling to them why advanced economies haven’t invested in innovation, despite cheaper and cheaper capital to fuel those investments.
They couldn’t nail down why, but they suggested a few reasons such as fewer profitable ventures, decreased competition as players grow, and the shift from physical to virtual asset investment.
It’s well established that low rates trigger increased market concentration and falling productivity. Firms divert their research capital to essentially buy revenue, while households prefer non-productive investment such as housing. Why risk starting a business when your bungalow is rising $10k/month? But sure, it’s a mystery, B-Money.
The Era of Low Rates Are Over
Returning to low rates seen over the past two decades is unlikely, warned the BoC. “The forces that pushed neutral rates lower may have peaked or could change course,” stated the Deputy Governor.
None of those factors have shown any real sign of changing, but they must feel it coming. Advanced economies won’t age, developing countries will stop providing capital, and despite companies investing less in productivity, they’ll change their mind. Either that or they made 30 years of poor decisions and lost their lead to countries outside of the “advanced” sphere, and are now scrambling to right course.
“A lot of uncertainty remains. But it’s possible long-term interest rates will be higher in the coming years than what Canadians are used to,” said the Deputy Governor.
Adding, “The risks appear mostly tilted to the upside. In the Bank’s view, that makes it more likely that long-term real interest rates will remain elevated relative to their pre-pandemic levels than the opposite.”
Though the central bank also said rates would stay low through this year, was criticized by a bank for dismissing its role in driving home prices, used inflation generating tools while they said it was a global phenomenon they couldn’t stop, and hiked rates a few weeks after they said they would “pause” until the fall.
Higher rates might stick. They might not. In any case, the central bank’s public communications should be taken with a grain of salt under its latest leadership.
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