New data sheds more precise light on the bill that will result from the increase in interest rates and the cost of living. Unfortunately, they have barely been published when these projections are overshadowed by an increase in the cost of money expected to be greater than that used in the analysis.
The study released Wednesday by Royal Bank economists assumes the Bank of Canada’s overnight rate will hit 2% by October, double the current rate, which itself quadruples that of January. On that basis, the average Canadian household will need to spend almost $2,000 more on paying down debt by the end of 2023.
The impact will obviously be felt more among households in the lowest income quintile. The latter must spend up to 22% of their after-tax income on debt service, while this amount is half for households in the highest income quintile. “The rise in the debt-to-equity ratio (the amount of disposable income needed to make repayments) will also be much more pronounced for low-income Canadians through 2023, double that seen for high-income households,” indicates the analysis.
And for all households, only for mortgages, due to the surge in residential real estate prices, a 100 basis point rate hike today has a stronger effect on their income. 66% than ten years ago.
A conservative 2%
Royal Bank economists are the first to recognize that this threshold of 2% of the Bank of Canada’s target rate could be exceeded. Because the discourse of central banks in the face of an inflationary surge, constantly revised upwards and expected to persist longer than expected, now suggests more energetic action by the monetary authorities. Especially since the game of expectations of households and businesses is worrying, to which is added an acceleration of wage adjustments, reflecting both the rise in prices and the shortage of labour. All of this raises fears of a disconnection, fueling a wage-price spiral that we want to avoid at all costs.
More economists are expecting a 75-point increase in the Bank of Canada’s target rate at the end of the monetary committee meeting in early June. And now to see the target rate reach 2.25% at the end of the summer and 2.5% at the end of the year. With the latter rate, we would find ourselves 75 basis points above the 1.75% rate observed before the pandemic, and with an increase of 225 basis points this year. If we take the calculations of National Bank economists that a 100-point increase would be equivalent to an erosion of purchasing power by 10.7%…
We note that, while the pandemic has had the effect of increasing debt, mainly mortgage debt, it has also contributed to generating excess savings to mitigate the shock. However, these savings are not distributed evenly. “Nearly a third of the total amount belongs to the highest-earning households (about $178,000 a year) and less than a fifth is held by those who earn the least (about $34,000 a year). For the latter, the excess savings have simply served to reduce the share of borrowing, a large part of the liquidities having been used to repay consumer loans”, underlines the Royal.
Moreover, the value of this additional savings suffers an eroding effect from high inflation felt more in the lower quintiles. And this lowest-income bracket devotes proportionally more resources to food, housing and other current expenses meeting basic needs—where inflation hits harder—than to services and discretionary spending.
Added to the impact of the rise in interest rates, inflation and the erosion of purchasing power. Apart from clothing and footwear, all prices rose, and more markedly. Soaring prices will have a profound effect on the purchasing power of low-income Canadians, who generally have to allocate a much larger share of their income to consumer purchases. “If the purchases of 2019, before the pandemic, were made today, they would monopolize 10% more of the net income of these households, compared to only 3.5% more for the households which earn the most”, underlines the Royal Bank study.
Real estate inaccessibility
The whole thing has to be put in the context of an explosion in the cost of home ownership and, by extension, in rents. “RBC’s overall Canadian home affordability measure recorded its worst level in 31 years in the fourth quarter of 2021. It rose 1.6% to 49.4%,” a rise in the index illustrating a deterioration, can we read in another analysis of the Royal Bank. “Over the past year, it has increased by 7.2%. “Only the year 1990 – having preceded the real estate crash of the beginning of this decade – was marked by a rise greater than this, notes the institution.
With rates expected to rise, and although revenue growth could partially mitigate the effects, “it is quite possible that RBC’s metric will reach record highs in the next year. Such a disruption would put buyers under enormous stress and put considerable downward pressure on demand.”