We will have to get used to it. The fundamental structural changes that the global economy is going through outline the scenario of high interest rates over the long term. As a defender of a 2% inflation target, the Bank of Canada will not be without being asked to review its calculations.
In the immediate term, the Bank of Canada’s monetary easing, which is still very recent, will do little or nothing to mitigate the payment shock that is hitting or awaiting households. Last May, in its 2024-2025 Financial Risks Report, the Office of the Superintendent of Financial Institutions indicated that of the total mortgages outstanding at that date, 76% would be up for renewal by the end of 2026. “Homeowners in Canada who renew their mortgages during this period could experience a payment shock, which will be more severe for those who took out their mortgages when interest rates were lower, between 2020 and 2022.” Higher-leveraged households who took out variable-rate mortgages with fixed payments—the famous five-year variable—will likely feel this shock more intensely. Especially since many of them find themselves in the so-called negative depreciation zone.
In a blog, the Financial Post noted, for its part, the forecasts of the analysis firm Oxford Economics that, despite the drop in interest rates in the second half of the year, mortgage payments will increase, on average, by another 6% by the end of 2024. By the end of 2027, they will be up 18%. According to Oxford, “the weight of the mortgage payment on disposable income is expected to peak at 9.3% around mid-2025 – the highest level since 1990 – before beginning to decline.”
Overall, the monetary austerity felt after the pandemic has fueled a significant increase in the household debt service ratio, which is one of the highest in so-called advanced economies. This pressure is all the more palpable given that Canadian households are among the most indebted in the world, Desjardins Group economists have already pointed out.
The era of high rates
In the longer term, the era of low interest rates, which gained momentum in the wake of the 2008 financial crisis, may be a thing of the past. In addition to tensions on international shipping routes and the impact of extreme weather on food prices, structural factors are currently outlining a change in trajectory, or even a reversal of forces, calling for long-term rates to anchor themselves at levels that were previously considered “normal”. A decline in global savings and a decline in globalization under the expansion of geopolitical tensions will modulate this balancing act between supply and demand, between savings and investment, influencing the level of interest rates.
“There will be no shortage of projects in the coming decades. Building more housing, making the energy transition, adapting to climate change and dealing with an aging population and international uncertainties are all elements that will require our economies to be able to adapt, and certainly require colossal investments. This will put pressure on interest rates and government budgets,” summarizes Desjardins in its “A Look at the Long-Term Issues Already Perceptible.”
It has already been written that central bank models indicate, for the moment, that the so-called neutral equilibrium rate—defined as the rate consistent with output sustainably remaining at its potential level and an inflation rate remaining at target—remains close to its pre-pandemic values. In Canada, this rate, which is also defined as the dividing line between expansionary and contractionary monetary policy, is currently between 2 and 3% in nominal terms.
In this emerging economic environment, the scenario of an increase in this equilibrium interest rate becomes more likely. In fact, it is generally accepted that it is unlikely that the real neutral rate will fall below the values estimated before the pandemic; on the contrary, there is a strong probability that it will increase. All this is in line with analysts’ observations that the forces that kept long-term rates on a downward trend during the 25 years preceding the pandemic are in the process of reversing.
And the inflation target?
In this perspective of an increase in the so-called neutral rate, one can very well imagine that the inflation target of 2% in the middle of the 1% to 3% interval retained by the Bank of Canada will have to be reviewed and moved upwards. All of this must be placed in a context of rebuilding supply chains and what is called geoeconomic fragmentation.
National Bank analyst Angelo Katsoras cites China’s deteriorating relations with the United States and Western countries as having intensified efforts to restructure global supply chains. This reconfiguration for geopolitical reasons, rather than for greater efficiency, means smaller supply chains will be created in higher-cost regions, he writes.
For its part, the International Monetary Fund continues to express alarm at the rise of geoeconomic forces in the form of the emergence of large blocs of influence and the polarization of globalization. The institution cites the example of Russia’s invasion of Ukraine in 2022, which caused a fragmentation of the main commodity markets. More pronounced geoeconomic fragmentation could be the cause of strong price variations, or even “large price gaps between blocs, particularly for minerals essential to the ecological transition and agricultural products in high demand.”