Higher interest rates—the effects on Canadians today and tomorrow

Last week the Bank of Canada increased its policy rate to 5 per cent, continuing the process of increasing borrowing costs to slow the economy and reduce the inflation rate (though the economy continues to perform rather robustly).

Needless to say, the chorus of criticism as the Bank raises rates has grown with the hikes being seen as bad for consumers, mortgage holders, renters and landlords. However, despite a recent drop, the Bank does not see inflation returning to the 2 per cent range until probably 2025, which raises the prospect of another rate increase down the road. And the Bank does not see interest rates returning to pre-pandemic levels once inflation is tamed.

The theory behind an interest rate increase is that by increasing the cost of borrowed money, aggregate demand will drop, bringing about an economic slowdown that will also reduce the rate of price increases. But after 10 rate increases the economy remains rather resilient, which is a testament to the continuing effect of labour shortages and supply chain disruptions, increased demand due to population growth, an ample supply of pandemic savings yet to be spent, and of course continued federal fiscal stimulus designed to “alleviate” the effect of higher rates while essentially working at cross purposes with monetary policy.

Even after inflation is eventually brought to heel, Canadians should not expect interest rates to return to pre-pandemic levels. Those low rates were in many respects a historic anomaly, as in the wake of the 2008-09 Great Recession they were kept too low for too long and then reinforced by the quantitative easing of the pandemic. There are important reasons to keep interest rates at more reasonable levels going forward—meaning a Bank of Canada policy rate closer to 4 per cent—given the long-term effects on savings, productivity and investment.

In the end, Canada has an economic productivity problem—a growth crisis. Over the last decade its per-capita GDP growth has been below the G7 average. Slow economic growth is rooted in declining business investment, and Canadian real per-capita GDP growth has been declining since the 1970s and is currently at rates last seen during the Great Depression. Over the longer-term, this means a declining standard of living.

Higher interest rates will have short- and long-term effects. In the short term, they will eventually slow the economy down, perhaps even move it into a brief recessionary period—again, that’s the point of monetary policy that raises interest rates to reduce inflation. However, in the long term, there are beneficial effects to this policy.

First, bringing inflation down ends the distortionary effect of higher and less predictable prices on the economy, making for better decisions by firms and consumers.

Second, higher interest rates will finally end the last decade’s “war on savers” that reduced the return to saving. Pandemic savings notwithstanding, low interest rates skew preferences from saving to consumption and more saving increases the pool of domestic capital available for investment purposes.

Finally, and perhaps most importantly, the end of cheap money is actually good for business investment from a productivity standpoint, in that it forces businesses to invest in projects with higher rates of return. This of course seems counter-intuitive in that standard economy theory says lower interest rates mean more business investment. But there are two aspects to business investment—quantity and quality. Low interest rates in the end may allow for less discerning investment decisions; every project that comes along can be funded. Higher rates means that more productive business investments with a higher rate of return must be selected given the higher borrowing costs. Moreover, low interest rates also fuelled the inflation of assets such as housing. The spike in housing prices in Canada is partly a function of chronic low supply growth combined with increased demand due to low interest rates.

So, the bad news is that higher interest rates will eventually come with some short-term pain. The good news is that, in the long run, a more reasonable range of interest rates will make for better and more productive business investment decisions that should positively affect long term per-capita GDP growth rates.