Interest Rates in Canada - Lower for Longer
This week’s decision by the Bank of Canada to trim its overnight lending rate by 25 basis points (from 1% to 0.75%) caught the markets by surprise and also embarrassed the country’s economic forecasting community. To my knowledge, not a single bank, brokerage or business economist (including this author) was predicting a cut in the Bank of Canada’s short-term policy rate. The Bank’s action reflects policymakers’ unease about the outlook for Canada’s economy at a time of slumping oil markets, weak global growth, and downward pressure on inflation in many jurisdictions. In explaining the reduction in the policy rate, the Bank of Canada pointed to projections that inflation will fall below 1% in 2015, well below the 2% target for total CPI.
In macro-economic terms, Canada has performed better than most other advanced countries since the 2008-09 recession and financial crisis – as the federal government never tires of reminding us. There are three main reasons: a well-functioning banking system; healthy housing markets; and oil. The economic prop provided by buoyant global oil prices, and the associated high levels of investment in the Canadian energy sector, has now disappeared. As the Bank emphasized in its January 21 statement, the shift in world oil markets is a major economic development from Canada’s perspective. In 2013, energy supplied one-quarter of Canada’s international merchandise exports, of which crude oil constituted the lion’s share. The broad energy sector also accounted for 37% of all non-residential capital spending in Canada in 2013. As the energy boom turns to bust, there is no doubt the economic pain will be widely felt across the country – albeit the brunt of it will be borne by oil producing provinces.
Housing market activity in Canada remains robust, but there is mounting evidence of over-valuation in some regions. By any measure, the country’s multi-year housing up-cycle (nationally, home prices have more than doubled since 2000 and are at record highs relative to incomes) is getting long in the tooth, to say the least. Canada’s banking and wider financial system is still in sound shape, but some lending institutions will be pinched by faltering growth in Alberta and other oil producing provinces as well as shaky loans to both energy companies and other industries that supply the oil patch.
For British Columbia, the move to even lower interest rates – rates that now seem destined to stay low for longer – should be positive for economic growth. In part, this reflects the heavy debt burden of the province’s household sector. Nationally, household debt is equivalent to about 160% of disposable income; we estimate that in BC the debt/income ratio exceeds 175%. It’s safe to say that historically low borrowing costs, including five-year mortgages at under 3% and variable rate mortgages at closer to 2%, will be well-received by many BC residents (if not by retirees struggling to live off of their savings) and provide an added boost to housing markets and some parts of the retail sector.
BC also stands to benefit from further weakness in the Canadian dollar associated with both tumbling oil prices and the market’s growing realization that Canada is set to lag well behind the United States in the timing of future interest rate increases. Now trading at barely above 80 cents US, the Loonie dropped by almost 10% against the US dollar in 2014. I expect it will lose more ground in the coming months, perhaps even testing 75 cents US before the year is over. For most trade-exposed industries in BC, including tourism, natural resources, manufacturing, film production, and parts of the advanced technology and professional services sectors, a weaker Loonie is a helpful tonic. In addition, retailers in the lower mainland will applaud as the ranks of British Columbians crossing the border to shop in the United States continue to shrink.
One concern about a shift to even lower for longer interest rates is the risks this may pose to financial stability over the medium term. Stated simply, record low borrowing costs will encourage households to take on more debt, even though debt levels in Canada are already high. In an era of exceptionally low interest rates, there is a tension between the goals of ensuring low and stable inflation, on the one hand, and promoting and safeguarding financial stability, on the other. This tension cannot be resolved by the central bank on its own; it also requires the engagement of other government policy-makers with control over regulatory tools affecting the wider financial system.
Recent developments in financial and energy markets will be reflected in the Business Council’s 2015 BC economic review and outlook publication, scheduled for release next week.