Fast facts:
The Bank of Canada has been trying to tackle high inflation with interest rate increases. Since March 2022, interest rates have gone from 0.25% to 2.5% in July 2022—a 2.25-point increase. The last time such an increase occurred in five months or less was in the 1990s. Before then, increases of this speed would occur a few times within a decade.
Previous attempts by the bank to quickly raise interest rates to cut inflation have always led to a recession. This time around, the combination of rising interest rates and all-time high household and corporate debt could be dangerous to the Canadian economy.
High private sector debt is the result of a policy of low interest rates since the early-2000s. Factoring private sector debt into the current economic reality, stormy clouds lay ahead:
- This recent period of low Bank of Canada interest rates substantially drove up private sector debt in the non-financial corporate and household sectors:
Private sector debt surged from the 100% of GDP range—where it stood from the 1960s to the 1980s—to its current value of 225% of GDP;
The last time we saw a rate hike of 2.25 points within five months’ time, in February of 1995, private sector debt stood at 142% of GDP—a full 83 points lower than where it stands today;
Incorporating private sector debt into our assessment of the impact that recent rate changes might have on the economy, we can see that the last five months of interest rate increases will have the third biggest impact on Canada’s economy in post-war history;
The second biggest impact occurred in November of 1992, when implied interest costs rose by 5.8% compared to the previous five months. The full impact never materialized because the Bank of Canada overnight rate rapidly dropped from its high of 9% in December 1992 to under 4% by July of 1993. That is, Canada dodged an economic bullet;
- The largest increase in implied interest costs occurred in 1980, when implied interest costs rose by a staggering 14.6 percentage points of GDP over the course of a year, from 12.6% of GDP in July 1980 to 26.8% in August 1981:
Those higher rates were maintained for much longer than in 1995, resulting in a deeper implied impact: it resulted in the longest recession in Canadian post-war history, starting in the third quarter of 1981;
If rates rise by 0.5% or more in the September 7, 2022 Bank of Canada meeting, Canada would shift into second-largest possible impact on the economy since 1961;
If rates rise by 0.5% or more in the September 7, 2022 Bank of Canada meeting, Canada would shift into second-largest possible impact on the economy since 1961; and
In short, even small changes to interest rates today can result in major economic consequences, due in large part to the high debt rate that the private sector has been amassing.
Introduction
While there has been plenty of attention paid to interest rate increases in Canada, there has been relatively little analysis of the impact of these hikes in the context of record-high household and corporate debt. The Bank of Canada is promising a soft landing, something I’ve noted is quite unlikely. What makes it even more unlikely is how much more potent rate increases can impact the economy today compared to previous episodes, due to near historically high private debt levels.
The size and speed of this rate tightening cycle
On its own, the Bank of Canada’s overnight rate or benchmark rate of 2.5% remains fairly low, historically speaking, despite increasing from only 0.25% in only five months. Prior to 2001, the bank’s rate had only hit 2.5% once before—2.51% in August of 1961. There were brief periods in 2002 and 2004 when the rate touched 2%, but 2.5% remains a fairly low value for the benchmark amount.
However, while the rate, as it stands today at 2.5%, remains historically low, the speed of the increases, rising 2.25 points from 0.25% to 2.5% in only five months, is fairly fast. There have not been any rate tightening cycles at that speed since 1995, which is more than a quarter century ago. Prior to that, though, rate increases of 2.25 points (or more) were happening several times a decade. It happened:
Three times in the 1990s;
Three times in the 1980s;
Twice in the 70s; and
Twice in the 1960s.
So while the absolute rate of 2.5% is relatively low historically, the rate of increase is fairly quick, certainly in the last quarter century. To understand the full impact of these rate hikes, we have to look at the debt load that those rates will be charged on.
Higher interest rates on much higher private sector debt
One of the common exclusions to modern economic models is debt and, in particular, private sector debt. During the Great Recession and the real estate crash in the U.S., insufficient attention was paid to skyrocketing household debt. I fear the same thing may be happening with this recent string of rate increases.
Much lower Bank of Canada interest rates over the past quarter century have led to much higher private sector debt held by households and corporations. This isn’t an accident. The lower interest rates were meant to entice the private sector to take out more debt to drive economic growth, which it did with gusto.
Standard economic models were built under the assumption that businesses will put that debt to productive uses, such as education or investments in new factories, thereby enhancing long-term productivity. Unfortunately, that new debt can just as easily be put to completely unproductive uses, such as bidding up the price of houses, buying up competitors, or just taking out loans to pay off investors.
This recent period of low Bank of Canada interest rates substantially drove up private sector debt levels in the non-financial corporate and household sectors, from the 100% of GDP range, where it stood from the 1960s to the 1980s, to its current value of 225% of GDP.
The last time we saw a rate hike of 2.25 points in five months, which was in February of 1995, private sector debt stood at 142% of GDP—a full 83 points lower than where it stands today.
There’s danger in comparing similarly sized rate increases while ignoring the debt that those rates will be charged on. To get a better idea of the impact of this rate-tightening cycle, we also need to account for the higher debt levels. To do so, I’m calculating the implied interest charges, which is the Bank of Canada overnight rate multiplied by the private sector debt-to-GDP ratio. The implied interest charges are a percentage of GDP and would be the interest that a company or household pays on its debt at the new interest rate.
There are important caveats. Most private debt is not immediately re-priced at the new interest rate. It will generally take years for that to happen. For instance, the interest rate on a fixed-rate mortgage will only be affected when the mortgage is renewed, with the terms typically being five years. As well, debt holders can change the terms of the debt—for example, extending the amortization—to spread the higher debt charges out over a longer period of time. The goal, though, isn’t to make economic projections but, rather, to estimate the potential impact of rate changes.
The last figure examines the change in the implied interest costs over the previous five months. The last five months’ worth of rate increases have an implied interest cost of just over 5% of GDP. This assumes that current higher rates are maintained for some time and don’t increase in the Bank of Canada’s September announcement.
By incorporating debt into our assessment of the impact of recent rate changes, we can see that the last five months of interest rate increases will have the third biggest impact on Canada’s economy in post-war history.
The second biggest impact occurred in November 1992, when implied interest costs rose by 5.8% points of GDP compared to where it stood five months before. The full impact of those implied interest costs never materialized because the Bank of Canada overnight rate rapidly dropped from its high of 9% in December 1992 to under 4% by July 1993.
The largest increase in implied interest costs over a five-month period occurred in 1980, when implied interest costs rose by a staggering 14.6 percentage points of GDP over the course of a year, from 12.6% of GDP in July 1980 to 26.8% in August 1981. These higher rates were maintained for much longer than in 1995, resulting in a deeper impact: debt was repriced at higher interest rates, which led to the longest recession in Canadian post-war history, starting in the third quarter of 1981.
The speed and size of the increase in implied interest costs over the past five months ranks among the top three biggest impacts in Canadian history.
Rate hikes probably aren’t over
But it’s quite possible that the Bank of Canada rate hikes aren’t actually over with its next announcement on September 7, 2022. Inflation is down slightly, from 8.1% in June to 7.6% in July, but this is still well above the Bank of Canada’s 2% goal. So how would these figures change with another 0.5% or 0.75% hike on top of the 2.5% rate as it stands before the September decision?
With no further action we’re already quite close to moving into the second-highest implied interest hike since 1961. A hike in the overnight rate of 0.5% or more in September would catapult us into the second largest impact of Bank of Canada rates on the economy since 1961.
The 1980s interest rate shocks were exceptional in that the Bank of Canada created a recession through sky-high interest rates in order to reign in inflation, although at devastating cost. If the Bank of Canada rate rose to 4.25% or more, we’d see the equivalent impact on the economy today as we did in the 1980s, given the speed of these rate hikes and our private sector debt overhang.
We’re in a pickle, here are some other options
It just goes to show that the private sector debt overhang that’s been building since the early-2000s makes even small changes in interest rates very dangerous to economic growth. Interest rates were already a dangerous tool to control inflation; they are more potent now than at any other point in Canadian history. Canada needs alternatives to the interest rate sledge hammer—and fast. These alternatives should include:
Drive down house prices by changing the mortgage underwriting rules for investors to make real estate investing much less profitable;
Beef up the Competition Bureau’s mandate and resources to ensure higher prices don’t end up as higher corporate profits, to investigate concentrated industries, and to better protect consumers from price-gouging;
Reign in price increases where governments exert control, such as rent, post-secondary tuition, child care, transit, prescription costs (pharmacare), and dental care;
Protect the poorest by indexing provincial income supports, particularly social assistance;
Ensure that wages are keeping up with inflation and reflecting gains in productivity of workers over time; and
Expand the new excess corporate profits tax beyond banks and insurance companies.
