On Wednesday, the Bank of Canada increased its policy rate to 5 per cent, a level not seen since March, 2001. Citing continuing tightness in labour markets and still-firm consumer spending, the bank reasoned there is still excess demand in Canada’s economy, and that Wednesday’s rate hike was necessary to continue to bring activity in line with productive potential. But if that adjustment is already happening, this hike may turn out to be one too many.
Among the many challenges a central bank faces in a fight against high inflation is the mixed signals it gets as it hikes rates to get inflation down. In Canada, the year-over-year headline inflation rate fell to 3.4 per cent in May. However, most of that was driven by a fall in prices at the gas pump. Similarly, although one of the bank’s preferred measures of core inflation – which excludes some items, such as food and gas – fell to 3.8 per cent from 4.2 per cent over the same period, what is called “supercore” inflation – which looks at service inflation excluding shelter – is running much higher at 4.7 per cent.
GDP growth slowed in April, but the preliminary estimate for May looks to be quite strong. Still, the bank’s Business Outlook Survey from the second quarter pointed to an easing of labour shortages, with April job openings at their lowest level in two years. Consumer insolvencies rose in May almost to their prepandemic levels.
The bank’s job is to sift through all this data and determine what overnight lending rate would bring inflation back down to its 2-per-cent target over the next 18 to 24 months. And it is this lag between rate increases and economic activity that raises red flags about this most recent hike.
When the bank raises the overnight rate – the rate banks borrow from and lend to each other in the overnight market – other interest rates adjust as well. As these rate hikes take hold, new borrowing becomes more difficult, and existing borrowing becomes more expensive. Households and businesses spend less, which slows economic activity.
However, these rate increases don’t affect everyone at the same time.
Take the household mortgage market – an area that gets much attention in Canada because of our indebted households and expensive housing markets. Canada has the G7′s highest household debt-to-GDP ratio at 102 per cent. Yet this ratio tells us nothing about the ability of individual households to service that debt. The debt-service ratio – which is how much of their disposable income Canadians must use to pay their debt each month – sat at 14.9 per cent in the fourth quarter of 2019, the last full quarter before the pandemic. It fell as the pandemic set in and interest rates crashed. In the first quarter of 2023, the ratio was back at 14.9 per cent. Maybe we just haven’t seen these hikes work their way through to the consumer yet.
Only one-third of households with mortgages have seen payments increase since the bank started its rate-hike journey in the first quarter of 2022. If only 35.5 per cent of Canadians have a mortgage, this means, as a rough estimate, only 12 per cent of Canadians have seen their mortgage payments increase. Many more will face hikes soon as renewals continue through 2025 and 2026.
Another reason to think the adjustment is already under way is changes in household saving, which provide clues about future consumption. From 2015 to 2019, household net saving was approximately $528-billion. In the three years since the pandemic began, that figure jumped to just about $1.9-trillion. Saving rates averaged 2.25 per cent from 2015 to 2019 and 9.79 per cent since 2020. Net worth shot up. Excess savings takes time to draw down, but there are signs this is now occurring, with net saving levels not far off the fourth quarter of 2019, the growth in the money supply falling, and net worth below its 2022 first-quarter peak.
Delays on the timing of mortgage renegotiations, and uncertainty about how households will behave with all that excess saving, make it hard to gauge what overnight rate level will reduce demand sufficiently to get inflation sustainably back to the bank’s 2-per-cent target. Moreover, if inflation continues to fall, monetary policy becomes more restrictive – high enough to restrain economic activity – in real terms even with a constant overnight rate. Add all this to the fact that we have just experienced some of the fastest rate hikes many of us have ever seen, and there was a strong case for caution in the bank’s latest rate setting. If the adjustment was already under way, the overnight rate may now be at its peak, and the bank’s next move will be a cut.
Steve Ambler is professor of economics, Université du Québec à Montréal and David Dodge Chair in Monetary Policy at the C.D. Howe Institute, where Jeremy Kronick is director, monetary and financial services research.