Rising interest rates will make life harder for a lot of us, but do we ever need them.
Low rates are cheap calories and our financial system has gone soft on them. Higher rates are like a fitness regime that will help us get back into shape.
Rates could rise as soon as Wednesday, which is the next opportunity for the Bank of Canada to adjust its trendsetting overnight rate. The next two openings for the bank are March 2 and then April 13, with five more over the rest of the year.
The overnight lending rate is 0.25 per cent right now, the emergency low it was reduced to during the worst of the pandemic. Economists expect multiple increases this year, with Bank of Nova Scotia forecasting that the overnight rate will be 2 per cent by year’s end.
Higher rates add to the strain on households that have been hit hard financially in the pandemic. In a recent Angus Reid poll of 5,002 people, 39 per cent said they are worse off than they were last year. In 13 years of running this poll, there has never been a higher percentage saying they are worse off.
One-quarter of poll participants believe an increase in rates would have a major negative effect on their household finances. But higher rates are needed to create economic stability that will benefit these households and others.
One thing higher rates can do to help us all is tamp down inflation, which lately hit a 30-year high at 4.8 per cent. “Higher interest rates encourage saving and discourage borrowing and, in turn, spending,” the Bank of Canada says in one of its publications. “In response, companies increase their prices more slowly or even lower them to encourage demand.”
Recent inflation has been linked to supply-chain kinks caused by the pandemic, but pent-up demand from households that were unable to spend normally during lockdowns has also been a factor. Unfortunately, it takes a while for rate increases to do their work. That means an interim period of rising interest rates and high inflation, a two-pronged attack on household budgets.
Surging residential real estate prices illustrate how the housing market is virtually begging for higher rates. Without some sort of limiting force – rate hikes, taxation, tighter borrowing standards – house prices seem as if they will rise until either the last shreds of affordability disappear or we have a recession. Higher rates could slow the market down, thereby avoiding more extreme outcomes like a full-blown correction.
People have been cautious about adding to debt other than mortgages since the pandemic began, but the national debt-to-disposable-income ratio was a very high 177.2 per cent in the fall of 2021. We’ve grown comfortable with this extreme level of indebtedness because interest rates are so low. Higher rates should be a prompt to reduce debt levels and thereby put households in stronger shape for financial challenges ahead.
Media coverage of the ups and downs of interest rates tends to focus on borrowers, which makes sense because they’re more sympathetic as young home and car buyers, people renovating their homes using credit lines or treating themselves to a trip or splurge. But savers and conservative investors are also affected, and they need higher rates in a big way.
Don’t sneer at these people for not scooping up the huge returns from stocks or crypto currencies in the past two years. We all need money kept safe for emergencies or short-term savings goals.
Rates for savers have been suppressed by the Bank of Canada as part of its efforts to support the economy. When the central bank starts raising rates, savers will gradually receive a better return on their money.
Higher rates are nasty for the bonds and bond funds in your investment portfolio because they push down bond prices. But if you have new money to add, you’ll find that yields have improved a fair bit. If you bought an exchange-traded fund tracking the broad Canadian bond market right now, you could expect a yield of 2.2 per cent after fees. A year or so ago, you were looking at 1.4 per cent.
Many investors have been cutting back on bonds or avoiding them because of low interest rates. Don’t give up on bonds. They are necessary for many investors to offset the risk of stocks crashing.
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