David Larock in Mortgages and Finance, Home Buying, Toronto Real Estate News

Last week the U.S. Federal Reserve replaced its pledge to keep its policy rate
in a range of 0.00 to 0.25% until 2015 with a pledge to keep its policy rate at
today’s emergency levels for “at least as long as the unemployment rate remains
above 6.50%” and for as long as inflation “is projected to be no more than half
a percentage point above the committee’s 2.00% longer-run goal”.
This is big news for anyone keeping an eye on Canadian mortgage rates.
Despite Bank of Canada (BoC) Governor Carney’s claims to the contrary,
Canadian monetary policy is closely linked to U.S. monetary policy because our
economies are so intertwined (we sell about 80% of our total exports into U.S.
markets). The higher Canadian interest rates get compared to U.S. rates, the
more demand there will be for Canadian interest-bearing investments. This, by
association, increases demand for our dollar and causes the Loonie to appreciate
still further against the Greenback, making our exports more expensive. Given
the deep and broad linkage between our two economies, if the U.S. Fed keeps its
policy rate nailed to the floor for years to come the BoC will have little
choice but to keep its comparable overnight rate (on which variable-mortgage
rates are based) very close to its current 1.00% level over that same
period.
The Fed’s decision to change its policy-rate guidance from being time
specific to being data specific was really an attempt to give the market more
clarity around when will it eventually begin raising rates. Until the most
recent change, the Fed would just push the timeline for rate increases out into
the future as economic conditions worsened but this approach meant that
investors had to try to guess whether the Fed’s interpretation of the data would
be negative enough to warrant further extensions. In theory, tying future rate
increases to specific economic indicators could make the Fed’s future
interest-rate trajectory easier to predict, but upon closer examination I am not
convinced that this will be the case.
For starters, the U.S. unemployment rate is not always a reliable indicator
of the U.S. economy’s overall employment strength because it only counts people
who are actively looking for work. As such, it can be significantly impacted if
large numbers of people either enter or exit the job market (this is otherwise
known as a change in the “participation rate”). If employment picks up and people
who had given up looking for work become more optimistic and re-start their job
searches, the unemployment rate will rise, despite the fact that the employment
picture is improving. Conversely, if the job market worsens, more
disenfranchised people might stop looking for work, causing the unemployment
rate to fall, even though the job situation would actually be deteriorating.
To put this last point in perspective, if the participation rate falls
another 1.00% from today’s level, the U.S. economy could reach an unemployment
rate of 6.50% by sometime in 2013 even if there is no change in employment
growth. While fewer people looking for work would be a major negative, under
this scenario the Fed would have technically met its goal. The rise and fall of
the participation rate means that there will still be lots of room for
interpretation about whether changes in the unemployment rate are constructive
or merely technical.
Now let’s move on to the new million dollar question (or should we say
trillion dollar question given the current U.S. debt and deficit levels?): When
will the U.S. economy meet the Fed’s new unemployment rate target? Here are
several points to consider: