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It’s hard to grasp how abnormal today’s inflation really is, until you look back at history.

In relative percentage terms, consumer price index, or CPI, inflation is now more than 200-per-cent above its 20-year average of 1.9 per cent.

The last time inflation was triple its 20-year average was August, 1975. As those in their 60s and 70s may recall, from that point on the prime rate drifted lower for a few years before rocketing 14.5 percentage points in 42 months.

When people think about how high the Bank of Canada needs to lift rates today, the natural comparison is with the late 1970s/early 80s.

The typical counterargument to that comparison is that consumers are far more sensitive to rate hikes today than in the 70s because of higher indebtedness, so rates can’t go up as much.

And these folks are absolutely right. Canada can’t tolerate the same degree of rate tightening today. The problem is that we don’t know how much it can tolerate compared with the seventies – and neither does the Bank of Canada.

“The bank hasn’t done these calculations because our model would not capture structural differences [in the economy] between the two periods,” BoC spokesperson Rebecca Spence wrote in an e-mail.

Deputy governor Toni Gravelle did say in a recent speech, however, that highly indebted households could amplify the impact of higher rates. Then again, he also hedged by saying Canadians are in a better average financial position than in the last rate hike cycle that began in 2017.

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In any case, while the Bank of Canada is monitoring the sensitivity of the economy to interest rate hikes, it admits it can’t predict that sensitivity with precision.

The best we can do is ballpark rate sensitivity, using estimates from the likes of RBC Economics, whose models suggests Canadians are more than twice as sensitive to interest rate hikes as in 1990.

Finding comparisons back to 1980 is much harder. In 1980, the ratio of household debt to personal disposable income was just 66 per cent. Today it’s more than 2.7 times higher, although inflation-adjusted net worth per capita has also risen by roughly three times.

Most importantly, today’s basic mortgage debt service costs are at least 60-per-cent higher as a percentage of income than in 1980. So maybe we’re not a full three times more rate sensitive.

The takeaway is this…

If one argues that Canada’s economy is up to three times more sensitive to rate hikes than in the late 70s/early 80s, and it took 1,450 basis points of rate increases to break inflation’s back then, it could plausibly take at least 20 to 33 per cent of that today. Call it 300 to 475 basis points of total rate tightening. (A basis point is one-100th of a percentage point.)

That implies the potential for prime rate to exceed 6 per cent. We’re at 3.2 per cent today, after starting this rate cycle at 2.45 per cent.

The worst part is the BoC no longer has the luxury of hiking rates slowly, unless core inflation magically subsides, and pronto.

That’s unfortunate, because when it comes to housing values and consumer adaptation to higher borrowing costs, fast rate hikes are the absolute worst kind of rate hikes.

Variable rates will eventually be the undisputed leader

The lowest nationally advertised five-year fixed rate climbed another 10 basis points (bps) this week to 4.14 per cent. That’s 175-plus bps above the lowest comparable variable rates on offer.

Mortgage shoppers see these wide spreads and figure variable is the way to go. Can’t blame them.

What that spread suggests, however, is that the market thinks variable rates will go at least 175 bps higher in the next five years. So you wouldn’t be much ahead with a variable unless rates come back down in a few years.

That’s a strong possibility, but the problem is you have to balance that possibility with the risk that it could take more hikes than the market currently expects to bring inflation back to the bank’s target of around 2 per cent.

Once prime rate climbs another 150-plus basis points, the fixed-variable spread will become a secondary consideration. At that point, history takes over. And history shows that variable rates perform exceptionally well after prime doubles.

In fact, when the prime rate is more than 50-per-cent above its five-year moving average, variable rates historically cost less in the next five years than five-year fixed rates, well over nine times out of 10. And that’s going all the way back to before the Second World War.

The reason is simple: monetary policy works. Higher rates beget lower rates. That’s the beauty of rate cycles, and it’s why variables will ultimately be the only term of choice.

Lowest nationally available mortgage rates

TERMUNINSUREDPROVIDERINSUREDPROVIDER
1-year fixed3.39%RBC2.99%True North
2-year fixed3.64%RBC3.29%True North
3-year fixed3.89%Manulife Bank3.69%True North
4-year fixed3.99%Manulife Bank3.89%True North
5-year fixed4.14%Alterna Bank3.99%Nesto
10-year fixed4.94%HSBC4.44%Nesto
Variable2.39%HSBC1.99%HSBC
5-year hybrid3.37%HSBC3.51%Scotia eHOME
HELOC3.05%HSBCN/AN/A

As of May 18.

Rates are as of May 18, 2022 from providers that advertise rates online and lend in at least nine provinces. Insured rates apply to those buying with less than a 20 per cent down payment, or those switching a pre-existing insured mortgage to a new lender. Uninsured rates apply to refinances and purchases over $1-million and may include applicable lender rate premiums. For providers whose rates vary by province, their highest rate is shown.


Robert McLister is an interest rate analyst, mortgage strategist and editor of MortgageLogic.news. You can follow him on Twitter at @RobMcLister.

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