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Trevor Tombe: The lasting consequences of interest rate hikes

Commentary

Next week the Bank of Canada will announce its third rate decision of the year. After signaling a pause in further tightening, it is unlikely to move off its current 4.5 percent policy rate.

But inflation is currently at 5.2 percent, far above the Bank’s target range of 1 to 3.

So why would our central bank pause further increases while inflation remains so high?

Two reasons: first, inflation pressures have likely already ended, despite the high headline rate most coverage focuses on; and second, it takes time for interest rate hikes to have their full effect—and today, thanks to the large number of variable rate mortgages out there, it might take longer than usual.

On the first point, the data is crystal clear.

Excluding volatile components like food and energy, and excluding the policy-driven increase in mortgage interest costs, inflation is consistently within or below the target range for most of the past seven months.

Excluding these items doesn’t mean they don’t matter, to be clear. Increases in the price of any item can strain household budgets. But excluding volatile components provides a better indication of where inflation may be headed. Excluding mortgage interest costs also narrows our focus to prices determined by supply and demand rather than policy. 

But even including food and energy, prices have increased at an average annualized rate of less than 0.3 percent over the past three months and only 2.5 percent over the past six months.

The reason reported inflation remains so high isn’t because prices are rapidly rising. Instead, it’s because the calculation reflects all of the monthly price changes for the past year.

So despite the sharp recent decline in the pace of price increases, we have to wait until the large increases in the first half of 2022 fall out of the calculation. If recent trends continue, though, we could see close to normal rates of inflation by this summer—so there may be no more need for the Bank to tighten further.

The second point—that rising rates take time to fully affect the economy—is even more important. Especially today.

Higher interest rates affect our spending in several ways. Borrowing is more expensive, so we spend less on items that we typically use debt to purchase (such as vehicles, renovations, new homes, and so on). Higher rates also make many of us poorer (look at home prices recently), which leads to lower spending. 

Recent estimates suggest that each one percentage point increase in the Bank’s policy rate tends to decrease consumption spending by 1.7 percent—but this effect can take well in excess of two years to fully materialize. 

Today, another channel may complicate this picture and lead to even longer lags than usual.

When rates rise, people pay more to service their debt and so have less to spend on other things. Those with variable rate mortgages are particularly exposed, but not right away.

Many households with variable rate mortgages—which account for roughly one-third of all mortgages, and most of which have fixed payments—now have monthly payments that are less than what they owe in interest. Depending on the Bank, somewhere between one-fifth and one-third of all outstanding residential mortgages are in this situation.

The result: instead of the total amount owing going down as payments are made, their mortgages are actually growing each month. This “negative amortization”, as it is called, will continue until rates decline. And when these mortgages come up for renewal, monthly payments may have to rise significantly to make up for it. 

In effect, variable rate mortgages shift some of the burden of recent rate increases well into the future. And there were a lot of such mortgages issued right before the tightening cycle began. In fact, a majority of new mortgages had variable rates.

Much depends on the path of future rates, of course, but consider someone on a variable rate fixed payment mortgage that started at one percent on a five-year initial term. If they renew at three percent at the end of their term, monthly payments could rise by roughly one-third or more. On a $400,000 original mortgage, I estimate that could mean an extra $500 to $600 per month more than what they paid during the first five years. 

It will take several more years for recent rate increases to fully affect these borrowers.

Of course, one option to avoid a sharp increase in payments may include extending the mortgage amortization at the time of renewal.Be sure to talk with a professional advisor or mortgage broker; I’m not providing any advice here, just illustrating some general issues. But even this comes with significant, though somewhat hidden, additional interest costs over the life of the now-longer mortgage.

Either way, thanks to the larger number of variable rate mortgages out there, pressure on many households to lower spending may continue even long after rates fall back to normal levels. 

The Bank of Canada’s job is never easy; it is especially difficult today.

A pause in any further rate increases is entirely warranted, and we may even see cuts in the not-too-distant future. But since rate hikes over the past year may have unusually long-lasting consequences for Canada’s economy, our central bank’s job of managing recent disruptions is far from over. 

Pierre Desrochers: Fossil fuels—a huge net benefit to humanity 

Commentary

In the name of achieving “net-zero” (or carbon neutral) objectives and cleaning up the environment, many politicians have signed pledges to leave fossil fuels in the ground and to ban plastics. Almost never discussed in this context, however, is why coal, petroleum, natural gas, plastic, and composite materials were developed in the first place. The economic and environmental benefits of these things are either ignored or simply taken for granted. They shouldn’t be. 

Our ancestors would have never extracted fossil fuels on a large scale if these fuels had not delivered otherwise unattainable benefits or created lesser problems than what had existed before. In a lyrical tribute to his friend penned more than 200 years ago, Sir Walter Scott described James Watt as the man whose genius discovered the means of multiplying our national resources to a degree perhaps even beyond his own stupendous powers of calculation and combination.” Watt’s steam engine made it possible to bring the “treasures of the abyss to the summit of the earth” and gave the “feeble arm of man the momentum of an Afrite.” From then on, man was able to command “manufactures to arise, as the rod of the prophet produced water in the desert.” It afforded him the “means of dispensing with that time and tide which wait for no man.” Through his coal-powered inventions, Watt became a “potent commander of the elements,” an “abridger of time and space,” a “magician, whose cloudy machinery has produced a change on the world, the effects of which, extraordinary as they are, are perhaps only now beginning to be felt.” 

Watt’s invention created environmental problems, especially smoke and soot, but it also delivered significant economic, health, and green benefits. For instance, the massive industrialization and urbanization of the last two centuries not only resulted in the most significant growth in population numbers and income per capita in history, but also drastically improved the health and life expectancy of humanity. 

Fossil fuels also simultaneously delivered a “forest transition,” meaning an expansion of the forest cover in all advanced economies (and in an increasingly large number of developing economies) that spared many marginal wetlands, grasslands, and forestlands from the plough. This was possible due to the production of ever more food on ever less land and by the large-scale substitution of resources produced on the surface of the planet by others dug or pumped from below.

The first significant substitution was the displacement of fuelwood by coal. As English economist William Stanley Jevons observed in 1865, “forests of an extent two and a half times exceeding the whole area of the United Kingdom would be required to furnish even a theoretical equivalent to [the country’s] annual coal produce.” Luckily for humanity, the development of fossil fuels has since Jevons’ time continued to dwarf traditional biomass as a source of energy. 

Fossil fuels also provided key components for the creation of synthetic products that replaced materials once manufactured from animals and plants, to the benefit of whales (whale oil, baleen, perfume base), birds (feathers), and elephants, polar bears, alligators, and many other wild animals trapped or killed for their ivory, fur, or skin. Fossil fuels and synthetic products also obliterated the demand for wild and domesticated plants and trees that produced lumber, pulp, fiber, rubber, dyes, pesticides, and fertilizers.

Synthetic products drastically reduced the demand for animal fiber and leather while the replacement of work animals such as horses, mules, and oxen made much agricultural land devoted to their feeding and care available for food production or reforestation. As geologist Kirtley Fletcher Mather noted approvingly in 1944, a century earlier “nearly 80 percent of all the things men used were derived from the plant and animal kingdoms, with only about 20 percent from the mineral kingdom.” By the time of his writing, however, “only about 30 percent of the things used in industrialized countries come from things that grow; about 70 percent have their sources in mines and quarries.”

Paradoxically, climate change has become the dominant environmental issue of our time precisely because of the past creation of abundant, affordable, and scalable energy and synthetic products from fossil fuels. Banning these products in the absence of superior substitutes, however, can only recreate some of the very real problems they once solved, including threats to wildlife habitat and biodiversity.