Higher rates on the way, but not quite yet

(June 8, 2004) The Bank of Canada surprised few today when it announced it was maintaining its overnight lending rate of 2%, with the bank rate staying at 2.25%.

“Economic information received since the release of the April Monetary Policy Report (MPR) has been generally consistent with the bank’s expectations for growth and core inflation, and reflects the Canadian economy’s continuing adjustment to global economic developments,” read a statement from the central bank.

But the bank warned inflation could climb due to strong global demand for oil.

“All things considered, the bank’s outlook for economic growth and core inflation is essentially unchanged from the outlook in the April MPR,” the statement said.

There is a strong suspicion that the Bank of Canada is waiting for a cue from the U.S. Federal Reserve rather than adjusting rates unilaterally. The disparity between the two countries key rates was partly blamed for the soaring value of the Canadian dollar, earlier in the year. The sudden appreciation of the loonie was seen as damaging to Canada’s export sector, so it is unlikely the Bank of Canada will want to increase the current 1% gap.

In the U.S., the Fed has increasingly been hinting it will raise interest rates soon. Today, Fed chairman Alan Greenspan warned that while he planned to raise rates gradually, he would not hesitate to jack them up at a faster pace should the threat of inflation grow.

Such a move could decimate American consumers, according to a report out this morning from CIBC World Markets. The report warns that even a small move in interest rates could prove disastrous, since Americans are “leveraged to the hilt.”

To make matters worse, U.S. consumers are using floating rates on their debt, which take advantage of the current low rates, but leave them exposed to rate hikes. For example, 50% of new mortgages outstanding were adjustable rate mortgages, as of April, leaving 25% of household debt exposed to higher rates.

North of the border, the stereotypical conservative Canadian consumer stands on a somewhat firmer footing, with 30% of new mortgages carrying a variable rate, making up only 20% of current outstanding mortgages.

“In Canada, the situation is not as bad,” says Benjamin Tal, senior economist at CIBC World Markets. “The debt to income ratio is not rising as fast as in the U.S. and I think it is very reasonable to assume the Canadian housing market is not in a bubble.”

He says some U.S. markets may be experiencing a housing bubble, which could compound the problem for highly leveraged homeowners facing a rising mortgage rate. But Tal points out that the Canadian real estate market is far more sensitive to interest rate fluctuations.

R elated Stories

Advisors urge caution as CMHC eases rules for home buyers Helping clients tackle rising debt RBC attacks consumer debt “myths”

Another key difference between U.S. and Canadian consumer debt is the bankruptcy rate. In the U.S., it is between eight and nine per 1,000 people, while in Canada the rate is between three to three-and-a-half — and even that is considered high.

“In the U.S., I’m almost convinced that declaring bankruptcy has become part of long-term financial planning,” Tal quips.

All this does not mean the Canadian consumer is entirely healthy, though.

“In Canada the expansion of consumer spending over the past two or three years has been the most leveraged in the post-war era,” Tal says. “The main issue in Canada is that debt is rising much faster than income — at almost twice the rate.”

Filed by Steven Lamb, Advisor.ca, steven.lamb@advisor.rogers.com

(06/08/04)