16.9 C
Sunday, October 1, 2023
HomeCanada'Repercussions of Increasing Interest Rates and Decreasing Inflation: Borrowing Money is No...

‘Repercussions of Increasing Interest Rates and Decreasing Inflation: Borrowing Money is No Longer Economical’ | Breaking: Analysis


It will probably be hard to convince Canadians struggling with newly increased mortgage payments, but money has been free until recently.

Until recently, during that last rise in inflation, borrowing to buy something was actually a lot cheaper than waiting to buy it a year later. That’s because what economists call real interest rates were negative.

Even this week when the Bank of Canada raised interest rates another quarter of a percentage point to 4.75, the bank’s benchmark rate remains only slightly above the current rise in average prices.

But even that is relatively new. As Deputy Governor Paul Beaudry of the Bank of Canada explained Thursday in a speech to Victoria’s Chamber of Commerce, real interest rates have been falling around the world since the early 1990s.

According to Beaudry, that could change, not just until inflation is under control, but over the long term.

Get real on rates

For many people, the concept isn’t easy to understand, but according to Stephen Williamson, one of Canada’s top experts on central banking, the gap between real and nominal interest rates has a critical impact on the well-being of savers, customers and borrowers. And to explain it he uses apples.

“Suppose we only trade in apples,” says Williamson, Stephen A. Jarislowsky Chair in Central Banking at Western University in Ontario. “Suppose I borrowed an apple this year and I pay you back an apple in a year’s time, that’s a real interest rate of zero.”

A graph shows the real yield — or the difference between 10-year government bond yields and inflation expectations — which has fallen since the 1990s in Canada, the US, France, Germany and the UK (CBC)

In other words, although you have to replace it with another apple when the new crop comes in, the apple actually costs you nothing for a whole year. In general, that’s not the way we think the world works.

But with interest rates so low last fall, borrowing money at about three percent to buy a piece of furniture, for example, or even grocery items at 10 percent interest that could actually keep you on the shelf for a year has made you money.

In apple terms, that’s a bit like borrowing an apple now and paying it back minus one bite.

“That’s a good deal,” Williamson said in another interview a year ago. “I’d have to borrow like crazy.”

A hand holding a mostly eaten apple that is starting to brown.
A file photo of an apple core. Economist Stephen Williamson describes the negative real interest rates we’ve experienced as borrowing an apple and paying it back minus a bite. (CBC)

Borrow like crazy

That’s exactly what people did, borrow money at low rates, help drive home prices to astronomical levels, take Canadian consumer debt to world levels.

At the time, Williamson predicted that was something that couldn’t last and it hasn’t.

As Beaudry explained Wednesday, the Bank of Canada hasn’t had to worry about inflation in nearly 30 years. China’s opening to the global economy, globalization, high savings rates from boomers, and growing inequality that allowed wealthy people to invest and not spend, drove real interest rates below zero in 2018.

But due to a series of crises, including the COVID-19 pandemic and the Russian invasion, inflation suddenly surged above the Bank of Canada’s target range of two percent.

“In the whole period since 1991, when they started inflation targeting, they’ve never seen an episode like this,” Williamson said. “They have never been persistently above the inflation target.”

LOOK | Bank of Canada raises rates to 22-year high

Repercussions of Increasing Interest Rates and Decreasing Inflation Borrowing

Bank of Canada raises interest rates to 22-year high

The Bank of Canada has raised its reference rate to 4.75 percent, the highest since May 2001, making everything from mortgages to lines of credit more expensive.

Instead, in those days when unemployment was rising, the central bank cut rates and when unemployment was low, it would raise them a bit, he said. Inflation just wasn’t a problem and when it started to pick up in late 2021, it took central bankers around the world by surprise.

Before then, many people had forgotten how inflation worked. People who seemed content with a two percent pay rise a year ago, when Canadian inflation hit eight percent, would have been outraged by a six percent pay cut. But to an economist, they are both the same.

Raw purchasing power

Rising real interest rates have a similar effect when it comes to mortgages, Williamson said.

“The cost of buying a home isn’t just the dollar value of what you’re paying now, it includes all of these interest costs over time,” he said. “So if real interest rates are high, in terms of purchasing power, the raw purchasing power of your income as you pay off your mortgage, you’re paying higher real payments. You’re going to have to sacrifice more raw purchasing power that you’d otherwise use to buy other things .”

He said this is new and embarrassing for Canadians who paid low real interest rates on their mortgages while seeing their real estate rise between 10 and 30 percent. “That’s a really good deal,” he said.

But with interest rates at 4.75 percent and inflation at 4.4 percent expected to fall further, real rates are higher and rising.

“If you expect us to fall to three percent (inflation) in the future, or better still if we fall to two percent in the next year, that’s a very high percentage in real terms,” ​​said the Western economist.

“Now you’re at 2.75 (in real interest rates) and man, that’s a high real interest rate.”

A man in a dark suit gestures in front of a microphone, in front of Canadian flags.
Paul Beaudry, Deputy Governor of the Bank of Canada, speaks at the Bank of Canada headquarters in Ottawa, Ontario, Canada on June 2, 2022. (David Kawai/Bloomberg/Getty Images)

If Beaudry explained that on Wednesdaythe current rise in real interest rates due to short-term influences, what he calls “the bubble part,” is expected to be a brief, if painful, burst in the long-term rise of the economy.

But he warned that once inflation is tamed, there is no certainty that real interest rates will fall back to zero. As boomers spend their savings in retirement, as China’s population growth slows, as companies driven by climate change and AI innovation look to increase investment, global savings could fall, driving real interest rates down in the long run. to rise.

The author of what'snew2day.com is dedicated to keeping you up-to-date on the latest news and information.

Latest stories