Why Central Bankers Want Higher Inflation and What This Means for CDN Mortgage Rates – Monday Morning Interest Rate Update (August 18, 2014)

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

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These days, both the U.S. Federal Reserve (Fed) and the Bank of Canada (BoC), along with many other central banks in charge of monetary policy for the world’s largest economies, want higher inflation. That’s because in many cases, their inflation rates hover in the 2% or less range - perilously close to the zero, which puts outright deflation well within reach if a recession or another economic shock hits.

In today’s post I’ll explain why the Fed and the BoC are actively rooting for above-target inflation and I’ll outline the implications for borrowers who are trying to decide between fixed and variable mortgage rates.

In today’s environment, inflation moves an economy away from a central banker’s biggest fear – deflation. While central bankers are confident that they have the right monetary policy levers and tools to rein in inflation, they know that deflation is a much more cunning beast to tame. For example, the Bank of Japan (BoJ) has been trying to conquer Japanese deflation for twenty years, and it has only recently managed to stimulate a little inflation, although even the sustainability of this momentum remains an open question.

Recent fears of deflation are further exacerbated by the fact that many of the world’s central banks have already used up most of their dry powder defending their economies against the last financial crises, leaving them even more constrained than usual to fight new deflationary threats.

While it may sound counterintuitive when policy makers are charged with maintaining price stability, central bankers ideally do want some inflation in their economies - especially when mired in today’s low-growth environment where rising inflation provides a crucial buffer against deflationary risks.

If you’ve been following Fed and BoC commentary, you’ll be familiar with their ongoing guidance that rising inflation will be tolerated for as long as it takes to return their respective job markets to full health. A healthy job market includes rising labour costs, which are one of the most important drivers of inflation. Thus, the Fed and BoC’s repeated focus on healthy job creation dovetails nicely with their desire for higher inflation.

In its simplest form, the basic Keynesian theory that underpins most central-banker thinking is that gradually rising inflation causes consumers to buy now instead of waiting because they expect prices to rise in future, as opposed to deflation, which causes consumers to forego purchases because they believe prices will drop if they wait.

Inflation, at least the moderate kind, has some other benefits that come in handy right about now. For example, inflation reduces the long-term cost of repaying debt, because the number of dollars required to pay back debt remains fixed while inflation slowly erodes the real purchasing power of each of those dollars. Thus, inflation reduces the real cost of debt over the long run, which might not sound like a bad idea to a central banker these days when you consider that overall global debt has expanded by $30 trillion U.S. dollars, or 40%, since 2007, bringing today’s total outstanding global debt to a staggering $100 trillion.

Inflation also erodes the value of a country’s currency, which makes its exports more competitive. Of course, this assumes that the erosion in the value of one currency does not provoke counter measures from other economies, who generally respond with devaluation of their own. In the end, currency devaluation is a zero sum game that rarely produces a lasting benefit, but that doesn’t stop countries from trying it all the same.

In today’s world, however, any of these perceived (and controversial) tertiary benefits are secondary to the central banker’s main fear of outright deflation. That is why the U.S. Federal Reserve continues to artificially suppress U.S. interest rates, even in the face of improving U.S. economic data. Some fear that the Fed is already behind the curve and is risking significantly higher inflation by maintaining monetary policies that seem more appropriate for depression-era conditions. I think that the Fed understands perfectly well the risks that it is taking, but it would consider higher-than-target inflation a nice problem to have, and one it can much more easily deal with over the long run, when compared to the challenges of helping resuscitate an economy mired in deflation.

Of course the question for my readers always comes back to what this means for mortgage rates.

On the one hand, if the Fed and the BoC, among others, are actively trying to create higher inflation in order to put a stake in the heart of deflation risks once and for all, then it is unlikely that short-term interest rates will rise any time soon. Consider how difficult it has been for the Fed to generate higher inflation after years of unprecedented levels of monetary-policy stimulus. If the Fed isn’t going to stop until it achieves above-target inflation (say in the 3% range) for several quarters, then we may well be years away from higher short-term U.S. rates. Given the interconnectedness of U.S. and Canadian monetary policies, and the fact that BoC Governor Poloz hinted not so long ago that he is more concerned about inflation falling below target than rising above it, the same case can be made for short-term Canadian rates, which our variable mortgage rates are priced on.

On the other hand, if we do see higher-than-target inflation for an extended period, which seems to be an unofficial goal for both the U.S. Fed and the BoC, then borrowers who lock in might well enjoy a period when their mortgage rate is lower than the rate of inflation. In such a scenario, incomes would typically be expected to rise at least at the level of inflation, while fixed-interest costs would hold steady. This is often the scenario that many borrowers who opt for a ten-year fixed rate, in particular, are hoping will unfold.

The most important question in all of this, as is so often the case, is one of timing.

While it doesn’t look as though short-term rates will rise any time soon, they may rise quickly when the worm finally turns. Central banks are influential actors to be sure, and they are well equipped to lean against market momentum, but much like mother nature reminding us that she is really in charge from time to time, there is no question that the market can overpower central banks when duly motivated. Will the longest and largest period of debt expansion in history end with a whimper or a bang? History suggests the latter, and that infers that the market, not central bankers, will write the final words for this current chapter in our history.

When asked for my opinion in the current environment, I continue to believe that five-year fixed rates are a better option than five-year variable rates for most borrowers who are either in the market for a new mortgage, or who are looking to refinance or renew. To be clear, my view isn’t based on the belief that variable rates will rise anytime soon, it’s based on the belief that for most borrowers, the roughly 0.50% premium you can now pay to insure against any rise in rates over the next five years is unusually attractive. It is not often that this ‘rate-insurance premium’ is offered at so low a price, and given that, I think it’s a cost most borrowers should pay to eliminate their risk of having significantly higher borrowing costs over the term of their mortgage. That is, unless your crystal ball on the timing of when rates will rise is less murky than mine.

Five-year Government of Canada bond yields fell by three basis points last week, closing at 1.48% on Friday. Five-year fixed-rate mortgages are available in the 2.79% to 2.89% range, and five-year fixed-rate pre-approvals are offered at rates as low as 2.99%.

Five-year variable-rate mortgages are available in the prime minus 0.75% to prime minus 0.60% range, depending on the terms and conditions that are important to you.

The Bottom Line: I think the U.S Fed and the BoC are both looking for above-target inflation, and that neither will stop until they see it for an extended period, for the reasons outlined above. While that implies that it will be a long time before variable mortgage rates begin to rise, fixed rates offer the potential for below-market borrowing costs when that day eventually comes. Given that both fixed and variable five-year rates have the potential to win out, and given the narrow spread between these rates today (0.50%), I think five-year fixed rates are the better option today.

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, Move Smartly, and on his own blog: integratedmortgageplanners.com/blog Email Dave

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