Monday Morning Interest Rate Update (October 29, 2012)

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

Mortgage Update Pic

When the Bank of Canada (BoC) released its latest interest-rate
last Tuesday it did not shift to a more neutral stance on the
future direction of Canadian interest rates as many were expecting.

Well, not quite anyway.

In its carefully worded final paragraph, the BoC closed with the following

“Over time, some modest withdrawal of monetary policy stimulus will likely be
required, consistent with achieving the 2 per cent inflation target. The timing
and degree of any such withdrawal will be weighed carefully against global and
domestic developments, including the evolution of imbalances in the household

Here is what was noteworthy in that statement:

  • The phrase “over time” is new, and it implies a longer time horizon for
    future rate increases.
  • The BoC’s June interest-rate
    included the phrase, “To the extent that the economic expansion
    continues and the current excess supply in the economy is gradually absorbed,
    some modest withdrawal … may become appropriate.” No mention of the economy
    needing to be operating above potential to trigger rate increases this time
  • Instead, the BoC appears to have shifted its focus with the phrase, “The
    timing and degree of any such withdrawal will be weighed carefully against … the
    evolution of imbalances in the household sector.”

That is the first time the BoC has mentioned household debt levels in its
always-studied-under-a-microscope closing statement. Governor Carney has been
talking about the risk of our record and still rising debt levels for some time
but he has always acknowledged that monetary policy is a less-than-ideal tool
for fixing this problem. In the Governor’s own words, monetary policy is the
“last line of defence” against runaway debt.

Here is a little more background on how we got to this point and why Governor
Carney remains reluctant to raise rates to reign in consumer borrowing:

  • When the Great Recession started the BoC lowered its overnight rate to
    emergency levels in the hopes that businesses would take advantage of cheaper
    borrowing costs and invest in productivity improvements. (Canadian productivity
    levels have lagged behind those in the U.S. for many years and Governor Carney
    saw this as an opportune time for businesses to take advantage of both the
    strong Canadian dollar and our ultra-low borrowing rates to invest in
    productivity improvements.)
  • But the same low interest rates that were supposed to stimulate business
    spending were also available to consumers - who took full advantage.
  • In the end, increased consumer spending did much more to help the economic
    recovery than expanded business investment. But whereas business balance sheets
    were well positioned to take on additional debt, household balance sheets were
    already highly leveraged.
  • Governor Carney understood that while this surge in consumer borrowing rates
    provided much needed short-term economic stimulus, it was also adding
    substantial systemic risk because it led to record household debt levels and
    rapid house price appreciation across the country.
  • To fix the problem himself, Governor Carney would have to raise interest
    rates, but this would invoke powerful negative side effects. Specifically, it
    would raise the cost of borrowing for both businesses, at a delicate stage of
    their recovery, and for over-leveraged consumers. It would also push the price
    of the Canadian dollar to new heights and raise the cost of our exports, heaping
    more suffering on our already hard-hit manufacturing sector. (On that last
    point, Governor Carney acknowledges that the Canadian dollar now includes a
    price premium because it is seen as a “safe-haven currency”. You can just
    imagine the impact that raising our interest rates at a time when the rest of
    the world is lowering theirs would have on our
  • Thus, with only a blunt instrument to fix a problem that required a
    carefully targeted solution, Governor Carney publicly implored Federal Finance
    Minister Jim Flaherty to use his better suited regulatory policy tools to reign
    in household borrowing.
  • But unlike the BoC Governor, Minister Flaherty has to run for re-election
    and after making several rounds of changes to the underwriting rules used for
    high-ratio mortgage insurance, he is increasingly reluctant to keep trying his
    luck with more credit tightening. (If he pushes too hard, his interventions
    might be seen to have exacerbated any ensuing market corrections. This would
    probably be unfair, but in politics that’s cold comfort.)
  • So instead of actually raising rates, Governor Carney seems to be trying to
    do everything but. At the very least, he has quashed any bond-market speculation
    that the BoC overnight rate might be lowered and he seems to have made consumers
    less thirsty for the borrowing punch bowl. (The BoC estimates that our
    consumer-borrowing growth rates have been running at about 5.5% since the
    beginning of the year, compared to our long-run average of a little less than

Here are some other highlights from the BoC’s full Monetary
Policy Report
(MPR), which I always read with great interest:

International Economic Commentary

  • The U.S. recovery is progressing “at a gradual pace”, indicators in Europe
    “point to a continued contraction” and in China, “growth has slowed somewhat
    more than expected … though there are signs of stabilization”.
  • Estimates for global growth were left largely unchanged (slight -.1%
    revision to 2012) but the BoC’s base-case scenario assumes that “the crisis in
    the euro area will remain well contained” and that “a severe tightening of U.S.
    fiscal policy … will be avoided”. For my money, that leaves some gaping-sized
    wiggle room in their numbers.
  • “Relative to the July [MPR] Report, U.S. GDP growth in 2013 and 2014 has
    been revised up to 2.3 per cent and 3.2 per cent, respectively, owing to a
    larger policy response by the Federal Reserve than was previously expected.” I
    am not nearly as convinced that QE3 will lead to higher growth rates. In my
    opinion, the U.S. Fed’s quantitative easing programs have reached the point
    where they are pushing on a proverbial string.
  • “Excess supply in the U.S. economy is expected to remain significant until
    well beyond 2014, dampening underlying inflationary pressures.” I have long
    maintained that deflation, not inflation, poses the greater threat to the U.S.

Canadian Economic Commentary

  • GDP growth estimates of 2.1% in 2012, 2.3% in 2013, and 2.5% in 2014 from
    the July MPR were raised slightly by .1% in 2012 and .1% in 2014.
  • Core inflation is now expected to reach 2% ”by the middle of 2013” and total
    CPI inflation, which “has fallen noticeably below the 2 per cent target” is
    expected “to return to target by the end of 2013”. Both revisions pushed the
    timing of inflation increases farther into the future.
  • The BoC now expects the economy to return to full capacity “by the end of
    2013” (versus the Bank’s mid-2013 estimate in the July MPR). 
  • I couldn’t resist sharing this graph from page 4 of the October MPR. If you have ever wondered why our bond yields have been at record
    low levels for so long, and why the Loonie has traded at or above-par with the
    Greenback for some time now, look no further. (Well played Governor
    Carney.)Bank of Canada Graph
  • And in a related point: “The Canadian dollar has averaged 101 cents U.S.
    since the July Report, higher than the 98 cents U.S. assumed in July … and is
    assumed to average 101 cents U.S. over the projection horizon.”
  • The BoC estimates that the U.S. Federal Reserve’s implementation of QE3 will
    be “modestly positive for the Canadian economy, lifting the level of real GDP by
    about 0.4 per cent by 2014.”
  • “Growth in consumption is thus expected to be moderate over the projection
    horizon … the measures implemented in recent months by federal authorities are
    expected to contribute to a more sustainable housing market in Canada.”

Five-year GoC bond yields were 2 basis points higher for the week, finishing
at 1.39% on Friday. Five-year fixed rates are still widely available in the 3%

Variable rates can still be found with discounts in the prime minus 0.40%
range (which works out to 2.60% using today’s prime rate).

The bottom line: Last week I speculated that if the BoC didn’t
soften its interest-rate guidance to a more neutral position, it would be
because the Bank is still worried about rising household debt levels and not
because it really thinks rates are likely headed higher any time soon. That
still reads about right to me.

David Larock is an independent mortgage planner and industry insider specializing in helping clients purchase, refinance or renew their mortgages. David's posts appear weekly on this blog ( and on his own blog Email Dave

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