How Will the U.S. Fix its Debt Problem and What Will it Mean for Canadian Mortgage Rates? (Monday Interest Rate Update)

Dave Larock in Monday Interest Rate Update, Mortgages and Finance, Home Buying, Toronto Real Estate News

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Canada’s Consumer Price Index (CPI) has shown another drop in overall
inflation, to 0.5% in January. Over the same period, the U.S. CPI came in flat,
at 1.6%, for the most recent twelve months. 

The latest U.S. and Canadian CPI data bolster my belief that the Bank of
Canada (BoC) is more likely to  lower, rather than raise, its overnight rate as
its next move to maintain its medium-term inflation target of 2%.

That said, while I continue to believe that inflation will remain benign for
the foreseeable future, eventually, inevitably, it will rise in accordance with
the intentions of the U.S. Fed (more on that in a minute).

First, let’s look at how large deficits and high levels of government debt
have impacted our mortgage rates to date.

Much of the developed world is now mired in a mutually reinforcing cycle
where high government debt and deficits act as a drag on growth, which lowers
business and consumer confidence and with it, consumer demand. Low demand causes
disinflation and in such an environment, central banks lower their policy rates
to ward off the threat of deflation. They do this primarily to stimulate
spending and investment but also to lower the interest cost of financing their
governments’ deficits. If policy rates reach 0%, central banks like the U.S.
Federal Reserve then resort to unconventional methods, like quantitative easing,
to inject further liquidity into their economies. This allows all debt levels to
increase still further. It’s like a drug dose to an addict - it helps in the
short term but just makes the long term more difficult.

At a very basic level, bloated government debt and deficit levels have fueled
today’s low-interest-rate environment. Here’s how this feedback loop works:

  • The incremental increases in today’s high government (and consumer) debt
    levels are being used largely to finance current consumption, soaking up an
    increasing share of resources that might otherwise be directed toward investment
    and productivity improvements. (BoC Governor Mark Carney has been imploring our
    businesses to use today’s ultra-low borrowing rates to do just that since the
    start of the Great Recession, to only limited effect because businesses are
    rightly concerned about the future.) While there is some debate about the size
    of the difference, economists agree that private-sector spending produces a much
    greater multiplier effect for the economy than government spending. (The
    “multiplier effect” is the extent to which each dollar spent has an impact of
    greater than one dollar on the overall economy.) So when government spending
    replaces private spending, the economy suffers.
  • As government debt increases, it raises the prospect that higher taxes on
    the private-sector will be required to service it, dramatically so when interest
    rates rise and raise government borrowing costs as they must ultimately do. The
    spectre of higher taxes (or worse, financial crisis) is further exacerbated
    today in countries with aging populations and underfunded entitlement programs.
    The governments in these countries have little remaining flexibility to address
    their budget gaps and the experts I read estimate that each 1% increase in a
    country’s marginal tax rates will reduce its real GDP by 2 to 3% over the
    subsequent three years. Thus it is no surprise that business and consumer
    uncertainty continues to rise alongside government debt levels. It’s this lack
    of confidence and the consequent reduced circulation of money that explains why
    the Federal Reserve’s increases to the U.S. money supply have not produced the
    expected improvements in U.S. economic activity.
  • As business and consumer confidence falls, discretionary spending and
    non-essential investment is postponed, lowering overall demand. This reduced
    demand causes the rate of inflation to fall (a process known as disinflation).
    Disinflation and ultra-low short-term interest rates then put downward pressure
    on medium- and long-term bond yields. On such a sea are we now afloat.

The current ultra-low interest-rate cycle in the U.S. and Canada will
eventually end in one of three ways:

  1. Western governments resort to harsh austerity measures to bring budgets back
    into line with expenditures. (Highly unlikely for reasons of political
  2. Bond-market investors lose confidence in governments’ ability to repay their
    debts and bond yields spike to unsustainable levels, forcing one or more
    sovereign defaults. Once sovereign default occurs, bond-market investors get
    nervous and demand higher yields for all government debt. (Unlikely, but still
    possible in at least a few euro-zone countries.)
  3. Stronger economic growth causes the U.S. Federal Reserve’s newly printed
    trillions of dollars to start circulating in the U.S. economy, triggering higher
    levels of inflation and lowering the ‘real’ value of outstanding U.S. federal
    government debt. Although this inevitably results in higher interest rates that
    cost more to service, the deflating real value of the debt means that there is
    less of it to pay off in real terms. The lender gets his dollar back but never
    recovers the real purchasing power of the dollar that was originally lent. This
    is viewed as the most politically expedient outcome and examples abound
    throughout history. In the words of Hayek: “History is largely a history of
    inflation, usually inflations engineered by governments for the gain of

Canada has a small, open economy that is highly integrated with the U.S. so
we will inevitably import this U.S. inflation when it rears its head. History
has taught us what will happen next, the only real question is one of

Five-year Government of Canada bond yields were eight basis points lower for
the week, closing at 1.40% on Friday. Any short-term upward pressure on bond
yields (and therefore mortgage rates) has now been reversed as evidence of our
continued economic slowing continues to mount. Five-year fixed-mortgage rates
are once again widely available at sub-3% rates.

Variable-rate mortgages are attracting increased rate competition among
lenders and as the prospect of a possible BoC rate cut increases, I expect
borrower interest in this option to continue to increase.

The bottom line: Today’s high government debt and deficit levels have
helped fuel today’s ultra-low interest-rate environment. While it will never
acknowledge this publicly, the U.S. Federal Reserve’s long-term solution will
almost certainly be to inflate its way out of the debt. When this eventually
happens, we will see higher mortgage rates, but the latest CPI data tell us that
this development is still a ways off on the horizon. Rest assured that I’ll be
keeping my binoculars at the ready.

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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