Despite the hawkish tone from Bank of Canada, Parliament is feeling a little more dovish. One week after the central bank hinted at the possibility of raising interest rates, the Office of The Parliamentary Budget Officer (PBO) has released its projections. Looks like they don’t see interest rates moving higher until next year.
The PBO released its projections, and doesn’t anticipate a rise in interest rates until 2018. They believe it will hit a “normal” or neutral level of 3% by mid-2020. This would mean an average rate hike of over 0.31% per quarter. The relatively sharp, and somewhat ambitious, expectation is later than experts were predicting. It’s also a year later than the Financial Accountability Office of Ontario (FAO) has been anticipating.
Interest rate projections from today’s PBO release. The PBO uses a regression-based model that links policy rates to bond rates. This is opposed to the current lick your finger and stick it in the air model that most experts have been using to guess.
Why You Should Care
Interest rates impact how much money consumers have available to them. The cheaper the cost of borrowing, the less money they devote to paying interest on loans. They can take out larger mortgages, car loans, and credit lines. Note, consumers don’t make any more money, they just devote less of it to interest payments. There’s a good reason to have low interest rates, and a bad reason. Let’s go through both.
The Basic Case For Low Interest Rates
When consumers can borrow more money, they stimulate the economy. People and businesses can finance more goods at a lower cost. This creates a ripple effect – the more people spend, the more businesses have. The more businesses have, the more they can afford to pay their employees. The more they get paid, the more they spend. The cycle continues until the economy is booming and they can afford to hike interest rates. There’s a little more to it, but generally speaking it makes society feel more wealthy.
The most important things that benefit from low interest rates are mergers & acquisitions, industrial financing, and home prices. All three of these things depend on long term financing, so low interest rates make them cheaper in a way. Think of low interest rates as the Black Friday for buying really, really expensive things.
The Basic Case For Higher Interest Rates
The bad is really the same thing as the good. If left too long, people finance too much stuff, inflation runs out of control, and the price of goods expands to fill credit. Home prices are the most obvious example, where the increase in borrowing power had a direct correlation to home prices from 2005 until 2015. Prices rose mechanically with every drop in rates. That changed in 2015, when rates dropped to historic lows, and speculators realized there was almost no risk on shelter. The increased demand pushed prices faster and higher than ever. This resulted in a panic rush of buying, as buyers felt they were going to be priced out forever.
In economic terms, raising interest rates would lead to a fall in aggregate demand. Which is a really fancy way of saying it would kill cheap and easy credit. If cheap and easy credit made people feel rich, killing it would make people feel uh…not wealthy anymore. People that don’t feel wealthy don’t do things like engage in bidding wars or finance expensive cars. It would also increase the cost of the debt they are currently servicing, putting a little more pressure on household budgets.
While this would bring home prices lower, there are a few negative impacts that should be considered. When people don’t feel as wealthy, they stop spending money. Businesses that see a decline in revenues will not be as generous with employees. This has the opposite ripple effect, slowing the economy. So, is the economy strong enough to take a hit on rate hikes? Drop your thoughts below.
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