If the Bank of Canada hikes its key overnight interest rate 75 basis points next week, as a number of economists now expect, the sharpest spike in borrowing costs in decades will have seen the bank’s policy rate soar from just 0.25 per cent to 2.25 per cent in less than five months.
As steep as that sounds, however, skyrocketing inflation means real interest rates are at historic lows, and that could pose a problem for the central bank as it tries to cool borrowing.
Real interest rates, which are derived by subtracting the rate of inflation from the central bank’s policy rate, are key to making investment and saving decisions.
For savers, inflation eats into nominal returns. It’s the opposite story for those borrowers who are able to secure financing at a fixed interest rate, because inflation reduces the amount they must repay in real terms.
In a new paper, TD economists James Marple and Faisal Faisal illustrate the stimulative power of negative real rates. They point to the example of a Canadian household that takes out a five-year fixed-rate mortgage at the current posted rate of 4.6 per cent to buy an average-priced home. If average inflation comes in just one percentage point higher than expected, that household will save almost $6,500 in current dollars, which the economists note is equivalent to reducing the annual mortgage rate to about 3.4 per cent.
“The higher the expected rate of inflation moves relative to nominal borrowing costs, the more attractive borrowing today becomes,” they write. “If inflation expectations continue to drift higher, central banks will have to go even further in order to bring it to heel.”
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