For the past 18 months, the key economic question has been how high interest rates will go. With the Bank of Canada and other major central banks nearing the end of their monetary policy tightening campaigns, the question has shifted: How long will interest rates remain high?
The U.S. Federal Reserve brought this issue to the forefront with a new forecast showing that officials expect to cut interest rates more slowly than previously projected. The majority of Fed committee members now think the overnight rate will still be above five per cent by the end of 2024, only slightly below where it is today.
The Bank of Canada, European Central Bank and other peers have been sending their own signals that rate cuts are a long way off.
Financial markets have picked up on this higher-for-longer theme and run with it. As recently as April, traders were pricing in rate cuts by the Bank of Canada before the end of the year. Now, markets are pricing in no rate cuts before 2025.
Long-term bond yields have also raced higher in recent months, with investors betting that interest rates won’t fall that far from the high-water mark. Yields on two-year Government of Canada bonds have risen to just shy of five per cent from 3.5 per cent in May, while 10-year yields hit four per cent this week for the first time since 2007.
This repricing of long bonds has a direct impact on Canadian borrowing costs. Central banks really only control very short-term interest rates. Longer-term rates, which underpin things such as fixed-rate mortgages and business loans, are set in bond markets, based on investor expectations about influences such as future monetary policy, inflation and economic growth.
The hawkish language from central bankers and aggressive market pricing reflects both short- and longer-term forces. In the United States, economic growth has been much stronger than economists expected in the face of 11 interest-rate hikes by the Fed in a year and a half. In Canada and Europe, economic growth has begun to stall, but measures of core inflation remain stubbornly high, and in Canada, they have been moving in the wrong direction in recent months.
There’s also speculation among central bankers that the long-run resting point for interest rates – what economists call the “neutral rate” – may be higher than previously appreciated.
Of course, the path for interest rates isn’t set in stone. Central bankers and bond traders have misread the economic tea leaves many times over the past few years. And a number of Bay Street analysts think interest rates will start coming down much sooner than markets expect – particularly in Canada, where heavily indebted households face significant payment shocks when they renew their mortgages in the coming years.
Nonetheless, there is a growing sense that interest rates, even when they do start to fall, aren’t going back down to levels seen in the decade between the global financial crisis and the COVID-19 pandemic. And that has major implications for Canadian homeowners, businesses, investors and governments.
“The real big question for a lot of economies, and especially in Canada, is this medium-to-longer rate,” said Paul Beaudry, a former Bank of Canada deputy governor who retired this summer and returned to his job as an economics professor at the University of British Columbia.
“For a lot of people – whether it’s for mortgages, whether it’s government debt, whether it’s firms, or the indebted economy in general – a few years of higher rates, it’s tight … but it’s not too bad. But if we are in a higher-rate environment, a real higher-for-longer one … there are a lot of adjustments that need to be made, and that’s really hard.”
Debates about the long-run path for interest rates have picked up as central banks prepare for a new phase in their fight against inflation. After pushing the overnight rate from 0.25 per cent to five per cent in a year and a half, Bank of Canada policy is now solidly in restrictive territory – that is, borrowing costs are weighing on economic growth and curbing domestic inflationary pressures. The story is similar in many other advanced economies.
While you can’t rule out further rate hikes, particularly by the Fed, the historic tightening cycle of 2022 and 2023 appears to have largely run its course.
That invites the question: What’s next? Bond investors are trying to answer that in real time, and several theories have come to dominate markets in recent months, according to Ian Pollick, head of fixed income, currency and commodities strategy at Canadian Imperial Bank of Commerce.
For one, investors are increasingly betting on a soft landing for the economy, especially in the U.S. That’s a scenario in which inflation falls back to target without a major recession or spike in unemployment. If that’s achievable, it would imply stronger economic growth, and less need for central banks to cut interest rates to stimulate growth.
There’s also the fact that inflation, while it has come down considerably over the past year, is proving stubborn. In Canada, the annual rate of Consumer Price Index inflation moved up to four per cent in August from 3.3 per cent in July. That’s twice the Bank of Canada’s inflation target. More worrying for the central bank: Measures of core inflation, which filter out volatile prices for items such as food and gasoline, also moved up in August.
“We’re seeing how persistent and sticky core inflation is and it’s starting to seep into longer-dated assets,” Mr. Pollick said. “People are saying, ‘You know what, I think there’s a lot more inflation in the system. And if it’s going to be higher for longer than we thought, we need more compensation to own these longer-term interest rates.’ ”
These arguments have fuelled the rise in bond yields and bolstered investor expectations that interest rates aren’t coming down any time soon. However, Mr. Pollick believes markets may be overreacting, particularly in Canada, where the economy is slowing and unemployment is on the rise.
“We think, over the near term, you end up in a situation where bond yields will have to fall because you have a deteriorating backdrop of fundamentals,” he said.
Royce Mendes, head of macro strategy at Desjardins, echoed this view. Canada is more sensitive to interest rates than the U.S., he said, because of the high level of household debt here and shorter mortgage terms, which typically reset every five years, compared with 30 years in the U.S.
Many homeowners are facing major payment shocks when they renew their mortgages over the next two years, particularly buyers who stretched their finances to purchase properties during the COVID-19 real estate boom.
Based on the current market-implied path for interest rates, Mr. Mendes estimates that borrowers with variable-rate mortgages renewing for the first time would see monthly payments jump by more than 50 per cent. Borrowers with fixed-rate mortgages renewing for the first time would see payments jump around 30 per cent.
A shock of that size may be untenable, and could spur the Bank of Canada to start cutting interest rates sooner than markets expect, Mr. Mendes said.
“We see this really as an economic issue where people need to take money away from their discretionary spending and put it towards debt service. Whereas if you’re using the market-implied rate, now you have to start questioning whether this is a credit issue and defaults would rise more materially than what most economists are looking for, which is sort of a mild recession in Canada,” Mr. Mendes said.
In many ways, the situation is more challenging in Canada than in the U.S., according Mr. Beaudry, the former central banker. In the U.S., central bankers, led by Fed chair Jerome Powell, may need to keep rates higher for longer because economic growth is strong. In Canada, the same medicine is being prescribed despite a weakening economy because inflation is moving in the wrong direction.
“When Powell is bringing this up, he’s kind of reacting to the economy being strong as opposed to just looking at the inflation numbers, where it doesn’t look too bad,” Mr. Beaudry said.
“The flip side, in the case of Canada, the economy is closer to what you might think is balance in terms of demand and supply. But the core [inflation] stuff isn’t coming down as much. And that makes that story a bit harder. ... It’s almost like now you’re tackling more of that psychology of inflation, which we’ve always been worried about,” he said.
In the near term, the crucial question is: Will rates go up one more time, and how long will it be until central banks start cutting them? Over the longer term, it’s slightly different: How far will rates fall, and where will they settle once inflation is back under control?
Here you start getting into wonky debates about the long-run neutral rate. That’s the Goldilocks level at which the Bank of Canada’s policy rate would theoretically settle if inflation was on target and the economy was operating at full potential.
The neutral rate can’t be observed directly, only deduced by looking at how the economy reacts to a given level of interest rates. And it’s determined by slow-moving forces, such as demographics, government debt, productivity trends, and the global balance of savings and investment, not by short-term decisions by the central bank.
Estimates of the neutral rate have been trending lower for decades, falling from around five per cent in the mid-2000s to the current estimate of between two per cent and three per cent. Now, however, some economists think that the neutral rate may be moving higher, which could help explain the rise in long-term bond yields.
That includes top officials at the Bank of Canada. In May, Governor Tiff Macklem warned that “nobody should expect that interest rates are going to go back down to the very low levels that we’ve seen over the last decade or so.” Mr. Beaudry used his last speech as a central bank deputy governor, in June, to caution Canadians that the anchor point for interest rates could be moving higher.
The reasons for this, he argued, may include a decline in the savings rate as baby boomers move into retirement, and more investment opportunities stemming from the low-carbon energy transition. Other economists have pointed to fracturing global trade, which could push up the cost of imported goods, and the high level of immigration to Canada, which is adding to the country’s potential growth.
“I wouldn’t say the Bank of Canada knows that this is going to happen. But at the same time, it almost seems like a one-sided bet,” Mr. Beaudry said. “There’s not a lot of stories saying [the neutral rate] is going to be going lower than what it was before.”
Others are more skeptical. An International Monetary Fund paper published earlier this year argued that interest rates would likely revert to prepandemic norms in advanced economies once the current inflationary episode ends.
Jeremy Kronick, director of the centre on financial and monetary policy at the C.D. Howe Institute, said it’s unlikely the neutral rate has moved materially higher. But it could be at the upper end of the Bank of Canada’s current estimate range of two per cent to three per cent. And Canadians – households, businesses and governments – need to be aware of that possibility, he said.
“Governments are going to have higher debt-servicing costs in that environment. And if they have less of a tax base bringing in revenue, well, it puts further strain on their debt servicing, which means higher interest rates,” he said. “I think that’s why a lot of economists are pretty adamant that governments get their fiscal house back in order in this country.”