Adjusting to higher interest rates

Speaking a day after we raised interest rates, Deputy Governor Paul Beaudry talks about what Governing Council considered in its decision. He also suggests reasons why long-term interest rates could remain higher than they were before the COVID-19 pandemic.

Policy rate increased by 25 basis points

Governing Council decided to raise the policy interest rate to 4.75%—the first increase since January.

This decision was based on an accumulation of evidence that points to excess demand in the economy persisting longer than expected, increasing the risk that inflation could get stuck above the 2% target.

Specifically, strong demand for both goods and services, a tight job market and signs of a rebound in the housing market all highlight persistent inflation pressures in the Canadian economy.

Long-term interest rates fell steadily for years

While the Bank sets the key short-term interest rate in Canada, long-term interest rates are determined by structural changes in the global economy. As they did in most advanced economies, long-term interest rates in Canada fell in the 25 years before the COVID-19 pandemic.

This decline was mostly due to lower real interest rates, which don’t include inflation. You get the real rate by subtracting inflation from the nominal—or posted—rate, for example, the interest rate on a mortgage or bank loan.

Real interest rates affect how much value there is in saving and how much cost there is in borrowing.

The level that short-term real rates should settle at over time is known as the real neutral interest rate. This rate can change because it depends on the balance between saving and investment in the economy.

Four key forces helped push long-term rates lower

Because Canada is a small open economy, the global balance between saving and investment matters more for the real neutral interest rate than what’s happening here at home.

Four key forces explain why saving was higher and investment was lower globally in the years leading up to the pandemic, pushing the real neutral rate in Canada lower:

• population aging in advanced economies—people save more as they approach retirement
• China and other developing countries joining the global economy—households in these places save a lot in response to things like weak social safety nets and less reliable banking systems
• rising inequality—wealthier households tend to save more
• fewer attractive investment opportunities for businesses

The four forces may be shifting and could reverse

The forces that pushed neutral rates lower may have peaked or could change course.

In advanced economies, many people who were saving for retirement are now retired and don’t need to save as much. And the share of saving that China and other developing countries contribute globally may shrink because aging populations will result in fewer new savers to replace retirees in those countries too.

Some drivers of inequality may also be waning. Globalization—which provided uneven benefits—may be stalling. And, since an aging population means it’s harder to find workers, wages could rise.

Finally, the transition to a low-carbon economy and artificial intelligence could spur more investment.

A lot of uncertainty remains. But it’s possible long-term interest rates will be higher in the coming years than what Canadians are used to.