Interest rate hikes will not shock

Predictions that interest rates will soar over the coming year are grossly exaggerated and ignore the damage such a move would inflict on the consumer sector, according to a leading economist.

In an economic briefing to the Canadian Institute of Mortgage Brokers and Lenders on Monday, CIBC senior economist Benjamin Tal said interest rates are not likely to balloon any time soon, despite warnings from North America’s central bankers.

He says the Bank of Canada currently expects to raise rates 150-200 basis points over the coming year. But he says a more likely scenario would be for the Bank to raise rates by 75-100 basis points over the next six months then stop.

The dilemma facing the Bank of Canada is that Canada currently has “two economies and one rate,” Tal says. While national inflation appears to be creeping higher, that is largely being skewed by massive growth in the oil and gas-rich western provinces.

In Ontario and Quebec, the manufacturing sectors have been pummeled by the high value of the Canadian dollar. Rising interest rates would drive the dollar higher and damage these economies even more. On the other hand, the western provincial economies are far less interest rate sensitive, so they are likely to survive even if rates remain relatively low.

In the U.S., attempts by the Federal Reserve to curtail spending with higher interest rates have been largely stymied by creativity in the mortgage industry. In the past, interest-only mortgages were by invitation only and directed to the affluent, who would invest their principal.

Now these mortgages are being pitched to the mass market, with the lower mortgage payments financing consumer purchasing. These tend to be adjustable rate mortgages, so a rising interest rate will affect the consumer greatly.

Another concern is that a dramatic increase in interest rates could stifle the housing market. Tal predicts housing prices will level off in 2006 regardless of any interest rate hikes and such a plateau will have an inflation-dampening effect of its own by eliminating the wealth effect.

The wealth effect is a purely sentiment-driven economic phenomenon. As a consumer’s net worth rises, so too does their spending, on average, regardless of their liquidity. According to Tal, for every $1 increase in a consumer’s home value, spending increases by five cents. Over the past three years, this has contributed $25 billion to the economy.

“I don’t think that the housing market is going to crash any time soon, because the fundamentals of the housing market are relatively healthy,” he said. “But the contribution [from the wealth effect] will not be available next year or in 2007 when it levels off.”

Rising house values have been increasingly important in fuelling spending, as wage growth has stagnated. Because of a growing movement to outsource not only manufacturing jobs to China, but service industry jobs to India, North American labour has lost much of its bargaining power.

“The pricing power of companies is not there anymore, because they cannot transfer higher costs onto consumers,” Tal said. “The bargaining power of labour is in the basement.”

Stagnant wages have limited pricing flexibility in the retail sector, driving demand for more of the cheap imports that are boosting the Chinese economy. As factories expand, more workers move from their villages to the city.

Tal estimates 25 million Chinese make the transition each year and once they settle in the city, they use three times more energy to maintain their new lifestyle.

“China and India consumed 50% of the increase in energy demand over the past few years, and they aren’t going to disappear,” Tal says.

As the price of energy rises, so too does the cost of shipping, he notes. And with China geographically isolated, developing economies like Mexico and those of Eastern Europe will become more competitive.

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

(11/08/05)

Steven Lamb