This week, there is a high probability that the Bank of Canada will raise interest rates by 25 basis points. To paraphrase the Governor, he wants to take his foot off the accelerator before the output gap totally closes. However, according to some articles in the press and some commentary, this may be the beginning of the end for the economy and we are now about to go through the gates of hell. The world of easy money, as we know it, is over. You want to buy a house in the GTA? Wait for two hikes and, according to some, you will be able to scoop them up by the dozen. One of my favourite headlines was “when rates go up, borrowers will pay”. That is something new. Imagine having to pay for the use of money. Worse still, imagine receiving something on your savings.
Everyone, take a deep breath and calm down.
Remember in the great Mel Brooks film Space Balls, Dark Helmut took his Space Ball One ship to “ludicrous” speed. Well monetary policy, especially in Canada, where we were proud that we never had a systemic financial stability issue, has been at “ludicrous” speed for the last few years. Our Dark Helmut is now taking it back to “ridiculous” speed. Even if rates went up 100 bp from here, monetary policy would still be considered accommodative.
But according to many, the slightest decrease from “ludicrous” speed is going to risk a destabilizing decline in housing prices and an ensuing banking crisis. A 50 basis point increase in the five year rate will increase a $250 k mortgage amortized over 25 years by about $70 a month. About one Starbucks coffee a day. If an individual has chosen to take on a mortgage payment with no buffer, and a lender has opted to take on this exposure, is it the Bank of Canada’s responsibility to immunize everyone from really bad decisions (or negligent compliance)?
The answer is no. But they are also aware that when moving rates higher, there will be casualties. The Bank has spilled plenty of ink on the vulnerabilities emanating from a highly leveraged economy concentrated in the household sector. They have looked at the impact on the financial system of higher rates and higher unemployment on the sector. They have determined that the impact of higher unemployment is much more detrimental than when rates increase. The banking system, along with government regulators, have also run their own stress tests to determine the impact on them of a housing collapse. Whether you agree with the results of these stress tests or not, the bottom line is that the Bank does. It is undertaking the first move, believing that if higher rates ultimately trigger a collapse in asset prices, the financial system would take losses but it would be able to absorb a substantial hit if it were to happen.
So when the Bank of Canada starts to raise rates, it will be with its eyes on where they expect inflation to be in 18 months to two years. If they raise rates this week, it is because they believe that the headwinds to achieve their inflation goal have lessened and they can let up on the gas. They are initiating this move with unemployment at very low levels, reducing the risk of an adverse aggregate impact from housing on the financial system from slightly higher rates. There could well be some borrowers who will become quickly stressed in the new environment and this will undoubtedly make headlines. However, as a policy maker charged with setting rates, the focus is not on the individuals who have put themselves in a vulnerable situation but rather on the resilience of the overall economy and the financial system in particular to absorb these losses. From the work done, the Bank feels confident that the chances of a repeat of the 2008 crisis, where problems in the financial sector propagated back into the general economy, are low.
So, if the Bank does hike this week, they are starting from a point when the Canadian economy is one of the strongest in the world, unemployment is low (by our standards) and our financial system is resilient. It would seem to be a good time to start to let up on the pedal. If not now, then when?
No comments:
Post a Comment