Playing with fire

The longer the Bank of Canada procrastinates to raise interest rates, the more financially vulnerable Canadians become.

In the wake of the 2008 financial crisis, central banks lowered interest rates to help with the recovery. So why, nearly a decade later, are the same banks procrastinating to raise rates, even though the economy is far from a recession?

 

That’s because, as the saying goes, they’ve painted themselves into a corner. And if they try to get out of it, they could muck things up.

 

After raising its key interest rate twice last summer, the Bank of Canada decided to maintain the status quo in October and keep it at 1%, well below the 5.75% of the early 2000s.

 

The bank is right to worry about how an interest rate hike will affect high household debt, which has grown faster than wages in recent years. According to a Canadian Payroll Association survey, 31% of Canadians said their debt load increased in 2017, and 42% of respondents believe it will take them more than 10 years to pay down their debt, compared with 36% in 2016.

 

Another source of risk is the debt composition. Since the Bank of Canada’s key interest rate influences the variable-rate mortgages and lines of credit banks offer — products Canadians have overwhelmingly opted for in recent years — more people are vulnerable to a rate increase. The Bank of Canada’s increase to its key interest rate in September, the second bump since the summer, did start to affect some consumers who had loaded up on such debts, although marginally.

 

That said, indirectly stimulating borrowing by maintaining rock-bottom interest rates will only make matters worse in the long run and further weaken the economy if the rates do go up. A really vicious circle.

 

NOT WORRIED?

Some economists are not all that concerned about this debt problem, for two reasons. First, low interest rates (and they should stay low for the time being) help homeowners reduce monthly payments on their mortgages and lines of credit. Second, low interest rates let people control their ratio of assets (such as home values) to debts. Why? Because the housing bubble, among other things, has caused property values to balloon — at least on paper.

 

At the same time, to stick with the same metaphor, the stock market bubble has inflated the value of our registered retirement savings plans. Low interest rates push down bond market yields, spurring investors to buy more stocks, which largely explains the record-high market indexes.

 

In short, Canadians’ financial stability is fragile. The paper value of assets is virtual and changeable. Housing prices are likely to level off or even drop in the not-so-distant future. The stock markets are facing the same fate. But Canadians’ debts will remain at the current levels and even keep on growing.

 

I don’t want to be a doomsayer, but any major change (job loss, separation, mortgage rate hike, financial crisis, etc.) could land Canadians in serious trouble. People should keep Murphy’s Law in mind: “Anything that can go wrong, will go wrong.”

 

That’s why the Bank of Canada is playing with fire by keeping interest rates so low for so long. Eventually, Canadians will have to rein in their credit-fuelled consumption and save more. And the only way to encourage them to do this is to raise interest rates. The economy will pay the price in the short term, but putting off the adjustment will only make things worse.