Household debt, U.S. top of mind for BoC
High borrowing loads and future of NAFTA preventing further aggressive rate hikes
OTTAWA— The Bank of Canada is already well into the process of raising interest rates to more normal levels and another increase is expected on Wednesday, after the economy’s stellar performance last year.
The big questions are how quickly do rates continue moving up from here, how closely will they follow U.S. increases and where rates will settle. Markets are pricing in at least three more increases this year, which would bring the benchmark rate to 1.75 per cent.
Canada’s economy, swept up by a synchronized global expansion, a housing boom and recovering oil prices, had a banner 2017 that included a sharp drop in unemployment and output growth that beat expectations. Policy-makers now worry the economy could soon overheat, triggering inflation. Which is why they raised borrowing costs twice last year.
The only remaining obstacles to further aggressive rate hikes may be high household debt loads and un- certainty about the future of the North American Free Trade Agreement — only one of which governor Stephen Poloz has any influence over.
Canadian households are easily the most indebted in the Group of Seven, and debt ratios have increased sharply since the 2014 oil shock. That means rate hikes pack a big punch in Canada by having an immediate and direct impact on the finances of many Canadians.
Just as debt servicing costs are rising, regulators are also pushing through measures to tighten mortgage eligibility, with the latest moves coming into force on Jan. 1.
Canadian households are not only facing more expensive debt payments, but the new rules threaten to dampen price gains for their main assets: homes.
All this will give policy-makers some pause.
The debt issue is important for another reason. It weakens the argument for Canada to follow U.S. rates higher.
Usually, over time, it’s not unreasonable to expect Canadian rates to converge with those in the U.S. On average, the two policy rates align and three hikes would allow Canadian rates to keep pace with the Fed, which began its normalization process sooner. Investors anticipate up to three more hikes in the U.S. this year.
Over the past 25 years, Canada’s policy rate has been about a rate hike on average higher than the U.S. rate. At the moment it’s 0.375 percentage points below, so there could be some catching up to do. But the U.S. — with its less indebted households — may be in a better position to cope with rate increases.
Unlike Canada, U.S. debt ratios have actually been on the decline. In addition, the difference in household debt loads not only could impact the pace of increases, but even affect where interest rates eventually terminate.
The Bank of Canada estimates its so-called neutral rate — a sort of Goldilocks rate that keeps the economy neither too hot nor too cold — at about 3 per cent.
The Federal Reserve sees its neutral rate at 2.75 per cent, according to the median estimate in their most recent projections in December.