Posted at 5:00 p.m.
The increase in the key rate by a central bank has a rapid effect on all the rates in force in its country. Credit card rates, bank loans and mortgage rates are also starting to rise. The same goes for bank deposits which, rather than being paid derisory rates, are rewarded with higher rates. This is the very purpose of the maneuver. By increasing the rates in force in its country, a central bank seeks to induce businesses and consumers to no longer borrow, but rather to save, thus ultimately reducing inflation. Of course, caution is also called for here.
A key rate that is too high or raised too quickly can curb all the enthusiasm for spending and investment by both consumers and businesses. This is the limited room for maneuver with which central bank governors have had to deal since March 2020.
In September 2007, two years before the debacle that followed the famous asset-backed commercial paper (ABCP) crisis, the Bank of Canada’s key rate was at 4.5. Wanting to stimulate the economy, the Bank of Canada lowered it gradually so that in the fall of 2008, it was at 2.25%. A 5-year fixed rate mortgage could then be obtained at a rate of 5.39% after discounts. Then, in the fall of 2009, came the crisis that we know. Wanting to support the economy, the Bank of Canada, like most central banks, let its key rate slide to 0.25%, so that a 5-year fixed rate mortgage was now trading at 4.04%. Ten years later, fearing an overheating of the economy, the Bank of Canada had gradually raised its key rate to 1.75%, a rate which it maintained until the start of the pandemic. As of March 4, 2020, the Bank of Canada moved quickly to stimulate an economy on the verge of a serious blow. On March 4, it lowered its key rate from 1.75% to 1.25%, then lowered it again to 0.75% on March 16 and 0.25% on March 27. In November 2021, the key rate was still at 0.25% while the Governor of the Bank of Canada, the same one who told us that there was no risk of inflation, repeated to anyone who wants to to hear that there was no question of increasing it.
However, if we study the recent evolution of the lowest rates granted for a 5-year mortgage, it emerges that the mortgage lenders, in particular the banks, do not seem to be of the same opinion as that defended by the Bank of Canada. Since their lowest threshold in January 2021, when some lenders were offering 5-year mortgages at a rate of 1.39%, this rate fell, in October 2021, to 1.94%. Shots, shall we say, but for a $300,000 mortgage spread over 25 years, this still represents increases in monthly payments of $77.88, or $934.56 on an annual basis. At a time when there is a very real risk of inflation and when household debt is rising, these amounts, even if they seem small, could be substantial.
These increases in interest rates occur while banks are only anticipating increases in the key rate. Imagine what will happen when the Bank of Canada does raise its key rate (and it will). The scenario that prevailed after the 2009 crisis is a good indicator of what is likely to happen.
When the Bank of Canada lowered its key rate from its floor of 0.25% to raise it to 1.75%, fixed 5-year mortgage rates rose to 3.25%. If such a scenario were to recur, the monthly payment on a mortgage balance of $300,000 would drop from $1183.81 with a rate of 1.39% to a payment of $1458.50 with a rate of 3.25% . An increase of almost $275 per month, $3296.28 per year. On the average budget of Canadian households, which is around $70,000 a year, it is still a 5% drain that will give them nothing more.
When boomers talk to “young” millennials about the impact that a rise in interest rates could have, they often tend to recall that they, in 1981, were paying close to 18% on their mortgage. These words are often perceived as so implausible in 2021 that we tend to discount them. However, a simple jump in the mortgage rate, very likely this one, from 1.39% to 3.25%, is still enough to make us think about the consequences that this pandemic and its aftermath will have on our consumption profile.
By the way, in our example of a $300,000 mortgage at a fixed rate over 5 years, if this rate were to go from 1.39% to 18%, this would represent additional payments of $38,583.96 per year.
Make it out ! – Our consumption between pandemic and climate crisis
Jacques Nantel, in collaboration with Robert Blondin
Somme editions, February 2022
158 pages
Who is Jacques Nantel?
Jacques Nantel has been professor emeritus of marketing at HEC Montréal for nearly 40 years, researcher and retail specialist. He is one of the best-known experts in his field of expertise and frequently speaks in the media. He is the author of numerous books – he notably co-authored the bestseller The Quebec Code – and has published more than 300 scientific and popular articles.