Via MoneySense (Original Article)
Why you should care about whether or not the Bank of Canada holds rates steady…
Despite all the attention mortgage rates get during Bank of Canada (BoC) rate announcements, our central bank’s focus is on the overall monetary policy of the nation. Monetary policy is the term that refers to the measures taken by the BoC to influence the economy by regulating the amount of money in circulation. In other words, it’s how the BoC tries to control the amount of money that flows in and out of Canada’s economy (both nationally and internationally).
History of monetary policy (and why it matters)
Up until the 1930s, the BoC’s monetary policy hinged on trying to protect a country’s exchange rate. As the rate dropped, central banks would become more restrictive about cash flow but this only helped push us into the Great Depression and was subsequently abandoned.
That’s when the central banks opted to monitor and control employment numbers. But by the 1970s North America was in one of the worst periods of stagflation—persistent high unemployment combined with high inflation—and this forced central banks to rethink their target. There was a brief stint with focusing on growing the nation’s money supply, but this broke down and by the 1990s central banks across the world were starting to adopt inflation rates as the primary target.
Since then, the primary objective for the Bank of Canada’s monetary policy is to keep inflation as close to 2% as possible. Technically speaking, inflation is an increase in prices, which reduces the purchasing value of money. Or in less technical terms: inflation makes the $20 you have today worth less in the future, because you can’t buy as much with that $20. It also means that your employer, who may be paying you $20 per hour now, will need to pay you more in the future. That’s precisely what the BoC wants through its inflation targets: to gradually and safely raise the standard of living for Canadians. Once the Bank sets its target-control inflation range, it analyzes the economy to see if prices are pushing up beyond that range, or falling beneath it.
In a nutshell, a 2% inflation target is the theorized equilibrium point between economic growth and a higher cost of living.
The BoC will use monetary policy to reach its 2% target by raising and lowering the target for the overnight rate (also known as the key policy rate or the short-term interest rate). This overnight rate is used by the BoC and by major financial institutions to borrow and lend to one another. How does that work? The target for the overnight rate is a half-percentage-point band. For example, the current BoC band is 0.25% to 0.75%. So, Bank A will loan money to Bank B at the top-end of the band of 0.75%. But Bank A will only give 0.25% in interest after Bank C deposits money with Bank A. The difference is known as ‘the spread’ and it’s how banks earn a profit (and raise funds for more loans, which are then used to earn more profits).
Major banks and lenders use the overnight rate as a guide when setting their prime lending rate (the rate at which the bank’s best customers can borrow money). By changing the overnight rate, the central bank signals to big banks to also change their prime lending rates. Because banking is a competitive business, most major banks will comply.
If the BoC wants to reduce inflation it needs to cool the market and does this by increasing overnight rates. Major banks follow suit, by raising interest rates on variable mortgage rates, car loans, and other consumer loans. The theory is that Canadians will spend less if it costs more to borrow and this reduces spending and, ultimately, inflation.
If, however, the BoC. wants to increase inflation it will drop its overnight rates. This allows banks, lenders and credit unions to lower their mortgage rates, personal loan rates and credit card rates, which should stimulate more borrowing from Canadians. The logic is that Canadians will spend more when it’s cheaper to borrow money; this increases demand and, subsequently, boosts inflation.
Keep in mind, we’re only talking about variable mortgage rates, at this point.
While variable mortgage rates and other floating rate loans, like lines of credit, will move up and down with the prime lending rate, fixed mortgage rates depend on bond market pricing. In simple terms, banks make the money they use to loan you a mortgage from the spread between what they lend and what they borrow. This spread is, in part, dictated by bond rates. So banks look at the yield, or interest rate of bonds to set fixed mortgage rates.
For example, if the five-year government of Canada bond is at 0.5%, the banks would take this rate and add percentage points to cover their costs. Since banks still need to be competitive, they’ll only add enough to cover costs and make some profit. In this example, let’s assume they add another 3.5% to that bond rate for a prime lending rate of 4%. In highly competitive markets, this prime lending rate can be discounted for ideal borrowers (good job, excellent credit scores, good debt-ratios, high down payments, etc.). So, you may end up with a five-year fixed rate mortgage at 3.25%.
Truth be told, bond market rates can move up and down far more frequently than the prime rate—and quite often on a daily basis. That’s because the bond market is tied to market fluctuations and investor sentiment. The phrase: “The bond markets have priced this in…” refers to how investors and the market set bond rates based on current and potential economic conditions, like whether or not the BoC will increase or decrease overnight rates or whether or not the U.S. Feds will increase their government bond rates.
The BoC rate is 0.5%, so why am I paying 2.7% on my variable mortgage rate? Banks use the BoC rate as a base. To determine a prime lending rate for home buyers and borrowers, banks will then add percentage points to this base, to come up with their prime lending rate.
Typically banks charge their best borrowers—people with excellent credit and good, stable incomes—an interest rate around 2% higher than the BoC’s target rate. So, if the BoC maintains its overnight rate at 0.5%, you can expect mortgage rates close to 2.5%.
Yet, even with the BoC cutting or keeping the target rate the same, mortgage rates have slowly crept up. Even fixed rate mortgages rates have crept up in the last few months, despite the fact that government bond yields are at an all-time low (more on fixed rates in a bit). These hikes are due, in part, because of new government regulations, which were designed to reduce risk in the country’s housing industry by forcing banks to set aside more money in case the mortgage loans on their books go bad. The banks have been passing on these additional costs to home buyers and loan borrowers. So, rather than finding a variable mortgage rate of 2.5%, you’re more likely to find a rate of 2.7%.
Some lenders will offer prime minus rates. That translates to a 2.7% prime rate minus 0.2% for a sub-prime interest rate of 2.5%.
Keep in mind, though, that we are still in atypical times. Normally in such a turbulent economy, with oil hovering at $30 US a barrel and the loonie sitting tight at 75 cents US, mortgage borrowers should expect a drop in mortgage costs, especially fixed rates. But there’s just nowhere to go. Or is there?
The BoC attempts to cool or heat up the economy by manipulating interest rates. But when rates start moving towards zero—as they have in Canada—a central bank may consider using other tools to stimulate the economy (remember, you can’t have inflation without economic growth).
One option is known as quantitative easing. This is when the BoC buys financial assets from the market (which can include government securities or private assets) in an effort to increase money supply and lower interest rates. This extra cash in the market prompts big banks to increase the supply of credit—provide more loans at cheaper rates—to households and businesses.
Another option is credit easing. This is the targeted purchase of private sector debt assets by the BoC. The aim is to reduce risk premiums, improve liquidity, and increase trading activity so that more money will flow in the market and demand for goods and services will increase.
In recent months there’s been discussion about whether or not Canada could become one of only a handful of nations to adopt negative interest rates. This is a policy where banks would charge savers to deposit money. So, rather than get 2.5% from that high interest savings account, you would have to pay 0.5% to the bank for the privilege of keeping that money in a savings account.
The idea is that by charging savers to save, the BoC is making it expensive to hold cash and this forces businesses, consumers and banks to start spending. It punishes savers and rewards risk-taking by making borrowing cheap. Basically, implementing negative interest rates is an act of desperation.
Fiscal policy (budgetary policy) refers to the measures taken by the government to increase or decrease public spending and taxes. According to most analysts, the Bank of Canada still has a number of monetary and fiscal policies it can use before resorting to negative interest rates. The biggest boost may come from the new federal government’s first budget, set for release on March 22, 2016. At that time, the feds could unveil billions in new stimulus spending (ie: fiscal policy) that could help prop up our country’s sagging economy.
Despite all this speculation around negative interest rates and new infrastructure spending, the Bank of Canada may not be done with interest-rate cuts, just yet. Almost half of the economic analysts predict additional BoC rate cuts at some point in 2016. The next decision is today, March 9, 2016.
Even though we now have a weakened dollar (which helps boost trade, which should help grow our economy), Canada is still struggling to gain momentum. As such, many economists predict that low oil prices will continue into the foreseeable future and this, combined with other non-resource sectors struggling in today’s economic climate, will mean slow growth for our economy. As a result, some analysts believe even more market stimulus will be required later this year from the BoC and this will require additional rate cuts.
If you’re buying a home?
If you’re in the market to buy a home then today is just another day. Even if the BoC raises or lowers rates today, both fixed and variable rates are already at such historically low levels that any impact on your savings or expenses will be minimal.
If you’re selling a home?
For home sellers today’s announcement is also good news. Because the BoC cannot alter the current target rate drastically, it means our nation’s housing market won’t receive any major economic shocks. This leaves an unhampered real estate market that will continue to grow and strengthen in the upcoming months. In most markets in Canada, the stable low rates coupled with low inventory means you win: it’s a seller’s market. This will translate into bidding wars and big gains for any home sellers (depending on your market).
Every prudent investor will tell you that if you borrow at a low rate and invest at a high rate, that’s sound financial management. But just because rates are low doesn’t mean you should invest in a real estate rental properties (or any other type of investment). Any decision to borrow and invest needs to be considered in relation to your overall financial strategy—and that strategy needs to consider the impact of rising rates. While we haven’t seen rates rise in more than half a decade, we all know that eventually rates will rise. That’s when a good bet can turn into a bad investment. This is one of the reasons why real estate investors lock-in rates. The interest on mortgages is a tax deduction, so locking-in gives investors both security of a low rate over time and the option to write-off that interest.
But homeowners don’t have that option (mortgage payments are not a deduction under current tax law). So, the best strategy for any home buyer is to focus on minimizing the interest paid on this debt but getting the lowest mortgage rate possible, but then creating and following a plan to tackle this debt.