Dave Larock in Monday Interest Rate Update, Mortgages and Finance, Home Buying, Toronto Real Estate News
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Today’s consensus on mortgage rates goes something like this: Central banks
around the world are printing money like crazy in an attempt to stimulate (and
reflate) their economies and to keep their governments (and in many cases their
banks) from going broke. All of this ‘new money’ will eventually lead to higher
inflation and when it does, higher mortgage rates will inevitably follow.
I agree with this general premise but it omits the most important detail –
when.
While the Bank of Canada (BoC) and many prominent Big Five Bank economists
have until recently been warning Canadians that higher mortgage rates could be
just around the corner, I have consistently subscribed to the view that this day
of reckoning will actually arrive later than most believe.
Today, let’s look at the impact (or lack thereof) that the U.S. Federal
Reserve’s actions have had on the U.S. economy over the last several years –
it’s a key element in my ‘lower-for longer’ view. I am focusing on the U.S.
example because the U.S. and Canadian economies (and monetary policies) are
tightly linked and if the U.S. economy experiences significantly higher
inflation, we will import it.
For starters, it may be splitting hairs but technically the U.S. Fed isn’t
actually ‘printing’ new money. Instead, it is expanding its balance sheet by
increasing its purchases of U.S. treasuries which it typically buys from U.S.
banks. That action increases each bank’s reserves but has no impact on the
amount of money that is actually circulating in the economy. If the Fed wants to
increase the supply of money circulating in the real economy it needs U.S. banks
to act as the transmission mechanism, and it is here that the first breakdown in
its master plan is occurring.
Despite its best efforts, the Fed has not increased either the banks’
appetites for lending, or consumer appetites for borrowing. When once asked
about how to deal with this specific problem U.S. Federal Reserve Chairman Ben
Bernanke famously said that if the banks wouldn’t start lending more he would
drop money from helicopters directly into consumer’s wallets, earning him the
nickname ‘Helicopter Ben’.
The Fed has been successful in engineering a massive increase in U.S. bank
reserves over the last five years, causing the U.S. monetary base to increase by
250% from $840 billion to nearly $3 trillion over that period. But the rate at
which banks convert reserves into money that is deployed into the economy,
called the money multiplier, has fallen sharply over that same period. The net
result is that the amount of money that is actually circulating in the real
economy, referred to as the money supply, has increased by only 35% since
2008.
Now 35% is a lot less than 250% but a 35% increase in the money supply is
still significant. If all else had remained equal, this might well have been
enough to get things moving again. But other elements have been changing as
well. Most importantly, the U.S. economy has seen a corresponding decrease in
the velocity of money.
The velocity of money is a measure of the rate at which money circulates, or
changes hands, in an economy. In simple terms, when money is circulating quickly
it corresponds with increasing demand and in this environment, inflation rises.
When the rate at which money changes hands slows, this corresponds with falling
demand and creates a headwind that can cause disinflation, or even outright
deflation.
The way that money is spent is arguably the primary determinant of its
velocity (and of whether it leads to further growth). When a business borrows
money to expand production or to increase productivity, this money is invested
in order to produce income that can then be used to repay its debt. This
stimulates growth and creates positive knock-on effects for the broader economy
(by increasing ongoing demand for raw materials and labour, for example.)
Conversely, when consumers or governments borrow to finance immediate
consumption this money provides no lasting benefit and produces no ongoing
income that can be used to service outstanding debt. Worse still, as this type
of debt accumulates it crowds out other more productive demand-generating uses
of borrowed capital, acting as a drag on economic growth.
To put the current U.S. economic backdrop in context, consider that the
velocity with which money now circulates in the economy has reached a six-decade
low. And this has happened at the same time that U.S. growth rates have averaged
1.8% over the last thirteen years (the lowest average growth rate over a decade
or more since the Great Depression).
The powerful forces described above have so far counteracted the U.S. Fed’s
quantitative easing (QE) programs and as private and government debt levels
continue to rise, both the money multiplier and velocity of money should slow
further. For these reasons, while I agree that we will see higher inflation (and
mortgage rates) at some future point, I don’t think the Fed’s QE programs are
necessarily a threat to near- or even medium-term future inflation.
Government of Canada (GoC) five-year bond yields were unchanged for the week,
closing at 1.18% on Friday. Five-year fixed-rate mortgages are widely available
in the sub-3% range and the most aggressive rate promotions are being offered to
high-ratio borrowers. While this may sound counter-intuitive, borrowers who have
less than 20% equity in their property are required to pay for high-ratio
mortgage insurance and this makes their loans cheaper to securitize. Lenders
pass some of that savings back to high-ratio borrowers with additional rate
discounting (usually five basis points). Notwithstanding this, borrowers with
more than 20% equity in their homes still enjoy a lower overall borrowing cost
because they do not have to pay to have their mortgages insured.
Five-year variable rates are currently available in the prime minus .40% to
.45% range (which works out to 2.55% to 2.60% using today’s prime rate).
The bottom line: The U.S. Fed’s unprecedented balance sheet expansion
has not yet triggered the higher economic growth the Fed hoped for - or the
inflation that most pundits have rightly warned us will inevitably arrive at
some future date.
Growth has been stifled in part because so much of today’s borrowed money is
being used to finance immediate consumption, instead of productive investment.
This is an unsustainable trend. And the Fed can only indirectly influence the
supply and velocity of money that is actually circulating in the U.S. economy.
If U.S. banks don’t want to lend and U.S. consumers don’t want to borrow, the
Fed can only watch and wait.
The combination of these factors underpin my view that inflation in both the
U.S. and Canada, and by association our mortgage rates, should remain at or near
current levels for longer than the BoC and most economists are predicting.
Unless Helicopter Ben wants to try firing up his rotors – then all bets are
off.
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
