Editor's Note: Dave's Monday Morning Interest Rate Update appears on
Move Smartly weekly. Check back weekly for analysis that is always
ahead of the pack.
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:
- Western governments resort to harsh austerity measures to bring budgets back
into line with expenditures. (Highly unlikely for reasons of political
- 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.)
- 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 (movesmartly.com) and on his own blog integratedmortgageplanners.com/blog). Email Dave