Interest costs are rising to keep inflation at bay
M ontreal homeowner Pierre Fortin made a calculated bet on his mortgage last summer. It was time to renew the loan on his sprawling 1951 bungalow in St-Lambert, a leafy neighborhood across the St. Lawrence River from downtown Montreal. Mortgage rates were at a 40-year low, yet the Bank of Canada had just announced a quarter-point hike in its trendsetting bank rate, to 3.5 per cent—the rate it charges banks for overnight loans. Was it a signal that mortgage rates were about to begin spiraling upward? Fortin, as it happens, is no ordinary consumer. An outspoken economist at Université du Québec à Montréal and a keen observer of monetary policy, he bet that interest rates were going to rise, but not by much— so he opted for a one-year term at 4.7 per cent.
So far, the world has been unfolding as Fortin expected. After months of thinly veiled hints, the Bank of Canada last week raised the bank rate to 3.75 per cent. With Canada’s economy racing ahead at full throttle, Bank of Canada governor Gordon Thiessen stepped lightly on the brakes by making loans for homes, cars and businesses a bit more expensive. His mission: to head off a possible resurgence of inflation long before the first signs of a comeback.
Hours after the announcement, Canada’s chartered banks raised the
prime lending rate for their best corporate customers by half a percentage point, to 5.25 per cent. Consumers were hit with a halfpoint increase in car loans, lines of credit and variable mortgages, all of which are tied to the prime rate. Even Thiessen was surprised at the extent of the banks’ hike in lending rates, which was double the increase decreed by the central bank. ‘We’re merely catching up with what we didn’t do in June,” said Royal Bank economist Lise Bastarache, noting that the banks kept their prime rates steady this summer after the Bank of Canada raised interest rates for the first time in two years. Bryan Griffiths, a Royal Bank senior vicepresident, explained the increase another way: because so many Canadians are putting cash into mutual funds instead of savings accounts and GICs, the banks are having to pay
higher rates to attract the money they need to lend to borrowers.
Last week’s increases did not, however, affect longer-term, fixed mortgages. Rates on terms of three or more years actually inched down in late September and fell again last week by between a tenth and a quarter of a percentage point. The new five-year rate is 6.7 per cent, its lowest level in three decades.
Why are mortgage rates dropping when the Bank of Canada is trying to make borrowing more costly? The reason is that banks finance their mortgage loans on the bond market, where rates rise or fall depending on currency fluctuations and whether investors judge inflation to be a threat. Right now, conditions could hardly be better. Most foreign investors believe the value of the Canadian dollar is likely to rise over the coming year; as a result, they are willing to accept lower rates in return for holding Canadian currency. At the same time, the inflation rate stands at 1.8 per cent and has showed no signs of rising despite robust economic growth and increasing job creation. Why? “It’s the $64,000 question,” says Bastarache. One possible reason is that technology is making workers more productive, reducing the cost of goods and services. Another theory is that competition from cheap foreign imports has made it harder for companies to raise prices. “We have to rethink our theories about the relationship between unemployment and inflation,” said Bastarache.
That, at least, is the view adopted by U.S. Federal Reserve chairman Alan Greenspan. Over the past year, Greenspan has resisted pressure to hike U.S. interest rates, which are now two percentage points higher than in Canada. Greenspan wants to see concrete evidence of inflation before he acts, while Thiessen appears to be taking no chances.
A few analysts expressed concern last week that Thiessen’s move might damage the recovery in consumer spending. But most economists are not worried—not even Fortin, who in the past has accused the Bank of Canada of discouraging job creation by keeping rates too high.
Still, Fortin is happy that he decided to lock in his mortgage for a year. By the time it comes up for renewal next summer he expects rates to be higher, but only by a percentage point or so—if only because Thiessen and his colleagues will not want to antagonize Canadians while unemployment remains high. Says Fortin: “Their behavior is just as easy to predict as your kid’s behavior when he sees chocolate or spinach.”
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