Interest rates are on the rise for the third time in six months, with the national cost of borrowing now set at 1.25 per cent. The Bank of Canada announced the rate hike in today’s announcement, citing strong economic performance and inflation. It could be the first of three expected moves which will eventually bring the Overnight Lending Rate to 1.75 per cent by the end of 2018. The rate is now the highest it has been in nine years.
The increase was widely anticipated following extremely strong jobs data earlier this month; after it was revealed a whopping 78,600 positions were added to the economy in December, pushing the unemployment rate to a 41-year low of 5.7 per cent, analysts pinned the likelihood of a hike at 90 per cent. Previously, it was expected the BoC would hold on tweaking monetary policy until at least its March announcement, as the market adjusts to new OSFI mortgage qualification regulations that took effect January 1. The central bank has been tightening monetary policy since mid-last year, when it raised its rate by 0.25 per cent in its July and September announcements, respectively.
Canada’s “big six” banks have responded to the increase by upping their Prime rates to 3.45 per cent.
A Widely-Expected Increase
The chance of a hike also fluctuated in recent weeks upon speculation that the United States would pull out of the North American Free Trade Agreement – a spot of uncertainty the BoC says is still “clouding the economic outlook”. However, each of the Big Six banks updated their forecast to indicate a hike was in the works, as well as increasing their own five-year fixed posted rates.
Strong economic performance in the U.S. is also a factor, with the Federal Reserve to raise its own rate by the end of January. The Bank of Canada often adjusts its monetary policy in tandem with its American neighbour.
Growth Spurt Won’t Last
However, while the BoC is reacting to robust growth at the end of 2017 and into the first quarter, it acknowledges some of the factors – particularly the impact of housing market demand – may be short lived, with growth poised to slow in the second half of the year.
“Looking forward, consumption and residential investment are expected to contribute less to growth, given higher interest rates and mortgage guidelines,” the BoC stated. It forecasts that Canadian GDP growth will slow to 2.2 per cent in 2018 and 1.6 per cent in 2019, following a booming 3 per cent last year. It also believes inflation will fluctuate in the medium term as temporary factors like gas and electricity – which have been in high demand due to cold winter weather – unwind.
And, while two more rate hikes are anticipated to come, the BoC says it will stick to its data-based approach before making any further monetary policy decisions.
“While the economic outlook is expected to warrant higher interest rates over time, come continued monetary policy accommodation will likely be needed to keep the economy operating close to potential and inflation on target,” it stated. “Governing council will remain cautious in considering future policy adjustments, guided by incoming data in assessing the economy’s sensitivity to interest rates, the evolution of economic capacity, and the dynamics of both wage growth and inflation.”
How Will This Affect Borrowers?
Because the Bank of Canada’s Overnight Lending Rate is used by consumer lenders to set the prices of their variable-rate loans, mortgage and line-of-credit holders with variable rates will immediately see today’s hike reflected in their monthly payments.
However, a rising interest rate environment has implications for all borrowers. A combination of rising yields for five-year government bonds – which the banks use to set the prices of their fixed-rate products –market competition, and today’s BoC increase have prompted the Big Six banks to hike their five-year posted rates to 5.14 per cent, from the previous 4.99 per cent. This is significant as the BoC uses an average of these posted rates when setting its benchmark qualification rate, which is in turn used as a standard when stress testing new mortgage borrowers.
This means new mortgage applicants will see the threshold for qualification rise from its current 4.99 per cent, making it tougher to pass the stress test, and could result in a lower mortgage approval amount. This double-whammy of reduced affordability and overall higher interest rates may cool the housing market further in 2018, as more prospective buyers save longer for down payments, or abandon their homeownership ambitions altogether. Those refinancing their mortgages will also incur a stress test, while those renewing their term with their current lender will do so in an all-around higher rate environment.
Fueling Debt-Risk Fears
There are also concerns that higher interest rates will pile onto already highly-indebted Canadian households, and lead to more borrowers taking out riskier debt to get by. As of December, Statistics Canada indicated the national debt-to-income ratio hit 1.71 per cent, meaning for every dollar earned, the average Canadian owes $1.71.
A recent study from the MNP Consumer Debt Index finds one in three Canadians say they struggle to cover their monthly bills and debt repayments, with 48 per cent within $200 of not being able to do so. A CIBC Consumer Research and Advice poll out last week reveals 60 per cent of Canadians would be “significantly less confident” about their finances should interest rates rise.
