The editorial answers you | How does the increase in the key rate reduce inflation?

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Vincent Brousseau-Pouliot
The Press

Why are mortgage interest rates raised to fight inflation when rising rates also help to raise your mortgage payment?

The quick answer: believe us, the Bank of Canada does not play with its key rate for fun. The last thing you want in the long term is an economy where inflation is out of control in the medium to long term. By raising the key rate (historically very low for years), the Bank of Canada is making the right decision in the circumstances.

We tend to forget it because we haven’t had any problems with inflation since the 1980s, but controlling inflation is a very important guarantee of stability for the economy. This is the task of the Bank of Canada through its monetary policy.

If inflation is too high and nothing is done, there is a risk of falling into an inflationary spiral: prices rise rapidly, people consume immediately and save little, the economy overheats, people see their power purchases erode and lose confidence in the economy.

On the other hand, we don’t want negative inflation (deflation), which discourages consumption and causes a recession.

“It is estimated that at inflation of around 2%, we counter the risks of recession and overheating of the economy. We balance the risks well,” says economist Pierre Emmanuel Paradis, president of the firm AppEco. The Bank of Canada is trying to contain inflation between 1% and 3%.

In Canada, inflation is currently at 7.0% (over 12 months).

Since March 2022, the Bank of Canada, which is trying to slow inflation, has increased its key rate by 3.0 percentage points, from 0.25% to 3.25%.

As the rates of financial institutions follow the trend of the key rate, mortgage rates have increased this year, to the chagrin of homeowners who have to renew their mortgage. For example, over the past year, the fixed rate for a five-year mortgage (closed rate) has gone from 2.24% to 5.54% at Desjardins.

On a mortgage of $320,000 (median price of a house in Quebec of $400,000, less the 20% down payment) over 25 years, the monthly mortgage payment goes from $1,392 to $1,961. It costs $569 more per month.

And it’s (undoubtedly) not over: to control inflation, Desjardins expects the Bank of Canada to raise its key rate by 0.5 percentage points by the end of the year, to reach 3.75%. That would mean another rise in mortgage rates.

And does this theory of raising interest rates to lower inflation work? Generally, yes. “By raising the rates, we give people less of a desire to spend and more of a desire to save. People consume less, it feeds inflation less, and it ends up decreasing, ”explains economist Pierre Emmanuel Paradis.

An inevitable consequence of this strategy: some homeowners see their mortgage payments increase, as you point out in your question.

Not everyone sees their mortgage payment increase immediately. Homeowners with fixed rate mortgages do not experience a hike until the end of the mortgage term (eg five years).

For many households, the mortgage payment is the largest expense item. But not for everyone. According to Statistics Canada, owner households spend an average of 15% of their total consumption on housing (this figure includes owners who have finished paying their mortgage).

Why didn’t Canada’s 2022 rate hikes immediately lower inflation?

First, it always takes a bit of time.

In addition, this time, two-thirds of inflation is attributable, according to the Bank of Canada, to two international factors: the global rise in the price of oil (consequence of the war in Ukraine) and supply problems (consequence of the pandemic, especially in China). The Bank of Canada has no control over these two factors which, it is hoped, will eventually resolve. The Bank of Canada has more control over the other third of inflation linked to the strength of the economy and consumption in Canada.

For 2023, Desjardins forecasts average inflation of 3.3% in Quebec, compared to 6.7% in 2022. Prices would therefore increase by another 3.3% in 2023.

However, we don’t want to hide from you: by wanting to slow inflation, we also slow economic growth. This is why many economists believe that we will enter a recession – which we hope will be mild and short – at the start of 2023. Desjardins Group economists are forecasting a recession in Canada for the first six months of 2023.

In the short term, it can be frustrating to see your mortgage payment increase.

In the long term, an inflationary spiral would do much more damage to your portfolio.