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How Household Debt Could Influence BoC Rate Cuts

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The number of Canadians overdosing on debt has made the Bank of Canada’s job far more complicated.

Before cutting rates, the BoC must now far more thoroughly evaluate how doing so could exacerbate financial risks.

As most of you know, one of the BoC’s key functions is to adjust the country’s interest rates to keep inflation as close as possible to its 2% target. If prices of goods and services start rising too quickly, the Bank raises interest rates to slow economic growth and inflation, and vice versa. The goal is to allow steady growth while ensuring your money holds its value.

But that 2% inflation level is a Goldilocks target. It’s hard to get it “just right.”

Moreover, the BoC has lots of leeway. It can choose to accelerate or defer rate changes even when inflation is off target, if it feels that will create longer-term price stability.

The “Newest” Normal for Rates

"Inflation for almost two years now has been very close to 2% and the economy has been very close to its capacity," BoC Governor Stephen Poloz told reporters during a fireside chat in January.

But now, leading indicators of Canada’s economic health are well below average and we have a global health risk (the Wuhan coronavirus) to worry about. Few expect its impact on global trade to be extreme, but at the same time it can't be underestimated.

That sets up a pivotal decision for the Bank of Canada at its next rate meeting. Markets are pricing in just a 15% chance of a rate cut at that March 4 meeting, but almost a 100% chance by July 15.

The problem is, lowering the overnight rate would reduce prime rate and other consumer rates. That would spur more borrowing and household debt accumulation, explains Bank of Canada Deputy Governor Paul Beaudry.

“A fall in interest rates can now cause an initial boom in economic activity as more household debt increases consumption,” Beaudry said in a speech last week. That increase in consumption could later become a drag on consumer spending, he added, as consumers are forced to pay it back.

“If a central bank in such an environment were to cut interest rates to stimulate demand and help inflation attain its target, this would generally favour an expansion—and increase inflation as desired,” he continued. “However, if there were financial vulnerabilities at play, this could turn out to be costly later.”

“Financial vulnerabilities, such as consumer debt, have the potential to accumulate sufficiently during the boom and eventually reverse the initial positive impact of lower interest rates,” Beaudry concluded.

The Takeaway

It now appears on the surface that the Bank is darned if they do, darned if they don’t. Between a rock and a hard place, if you will. (Insert your favourite cliché…)

“The key takeaway was that Beaudry implied there will be periods during which the Bank is willing to accept weaker baseline forecasts for GDP growth and inflation than might seem consistent with its mandate…if it means a better outcome in the worst-case scenario,” wrote Capital Economics economist Stephen Brown.

That would mark a shift in the BoC’s inflation paradigm. Financial stability concerns are not an explicit mandate in the Bank’s inflation targeting agreement with the government.

From a mortgage strategy standpoint, it’s another small reason to take a short-term fixed mortgage instead of a variable. A one- or two-year fixed, for example, moves independently from the BoC’s overnight rate. So if inflation expectations dive and bond yields fall, so will 1- and 2-year fixed rates most likely—even if variable rates barely move.

That said, no one should think the BoC is disinclined to cut rates when needed. “I don’t think of [housing vulnerabilities] as something that blocks us from changing interest rates,” Poloz said in 2016. And, in a 2014 discussion paper, Poloz wrote that such financial stability concerns “are not generally seen as a significant constraint on monetary policy actions.”

Of course, he’s probably changed his mind a bit since then.

Either way, if inflation expectations plummet, the BoC will cut rates regardless of debt loads. We might just have to wait longer for it to happen.