At a glance:
Ten months after the Bank of Canada embarked on a series of interest rate hikes to combat inflation, it’s increasingly clear the strategy isn’t working. Higher interest rates have dampened enthusiasm in the housing market but inflation remains stubbornly high on things like food, which is putting chronic stress on many Canadian households.
The Bank's own historical research shows that interest rates affect some prices a lot, but not most prices. Prices related to residential real estate are quite sensitive to interest rates. But most other prices, like for gasoline or food, are not.
To date, the only impact that rising interest rates are having is to decrease the price of private homes and real estate commissions. But even within the housing sector, the high cost of rent and rising mortgage interest rate costs are completely offsetting that impact—and then some. Overall, the data shows that interest rate hikes are increasing inflation, not decreasing it.
For instance, in November 2022, rent inflation hit its highest point in over 30 years of 5.9 per cent, driven by landlords passing on higher mortgage costs to tenants—clearly making a bad situation worse.
The Bank of Canada still seems intent on using interest rate hikes as a tool to lower inflation to its goal of two per cent. So far, that strategy isn’t working.
There are ways of keeping house and rent prices down without increasing mortgage interest costs: for example, the federal government could cut off tax breaks for businesses buying apartment blocks; it could clamp down on real estate investors by tightening mortgage rules and the provinces could set up better rent control to keep rent increases affordable for tenants.
Introduction
On January 25, the Bank of Canada pressed on with its program of interest rate hikes with a further increase of 0.25 per cent. December’s inflation numbers are out, and they’re slowly inching downward: inflation declined from seven per cent in August to 6.3 per cent in December 2022.
But over shorter time frames the decreases are more pronounced: three-month inflation is at 3.4 per cent inflation and six-month inflation at 2.9 per cent (annualized).
The Bank of Canada’s target is to bring inflation down to two per cent, although it is more concerned with “core” inflation that excludes gas and food prices. While the general rate peaked in June 2022, the Bank’s three versions of core inflation have been at or near all-time highs since June without a consistent decline yet.
So should we raise the “mission accomplished” banner? Did the Bank of Canada’s interest rate hikes starting in March 2022 wrestle it down from its June highs? At first yes, higher interest rates brought down inflation in the prices directly affected by rates. But by September, the balance shifted. Since then, interest rates have been making inflation worse.
Surprise: evidence shows some categories are hit harder by interest rates
First, we have to realize that the best available data from the Bank of Canada shows that not all prices are affected equally by interest rate hikes. Using Canadian data, the Bank measured the impact of interest rate hikes on expenditures, as well as timelines, on various goods and services. They found that some categories are much more sensitive to interest rate hikes than others. Moreover, some categories take longer to be affected once rates rise than others.
We’re now closing in on a full year since the rate hikes started in March 2022. However, the Bank’s own data shows that the maximum impact of rate hikes won’t be felt for 11 quarters after they start—which would be December 2024 for this cycle. There are huge lags between hikes and effects in the economy, and fine tuning the impacts is basically impossible.
However, even after four quarters (roughly where we’re at now) the Bank’s estimates show an impact of rate hikes, but it's very different across different categories. Figure 1 shows the change in expenditures by category for the four per cent point increase we’ve seen through December 2022 (from 0.25 per cent in Feb 2022 to 4.25 per cent December 2022). The Bank subsequently increased the rate to 4.5 per cent on January 25, 2023, but the inflation data only goes to December 2022.
Now that four per cent increase didn’t happen all at once, it happened across much of 2022. The Bank of Canada research shows the impact of interest rates on expenditures, not prices (ie. inflation). It would be better if we had the impact of interest rates on prices, but we don’t. That being said, expenditure changes are likely related to prices. Generally, as expenditures decline, so will prices as merchants try to attract more demand, although it won’t be a one to one relationship.
The fact that we don’t know the impact of interest rates on prices in any important categories is shocking. It's the entire foundation of what the Bank of Canada is doing and is causing havoc for anyone trying to take out or renew a mortgage. “Higher interest rates equals lower inflation” is the story told by economists, but here we are trying to implement this in the real world and data is completely missing. Talk about unexamined assumptions!
The Bank’s research suggests that housing related spending should be hit hard and fast by rate hikes. Ownership transfer costs (real estate agent commissions, for example) and new house construction have pretty direct corollaries in the Consumer Price Index—and Bank estimates, scaled to the current hikes, suggest expenditure declines of 21 per cent and seven per cent respectively. The slowdown in the housing market certainly backs that historical relationship. Renovations spending could be expected to fall eight per cent as well.
Beyond those categories, you see pretty small effects—under five per cent changes—in spending, even when scaled to the Bank’s historic hike. It would actually be even less than that as many of the hikes haven’t been in place for four quarters, just for one or two.
When people think of inflation, they often think of high prices of food and gas. But the best available evidence is that interest rates have historically had no impact on these categories. From the figure we can see that a four per cent increase in interest rates has a 0.04 per cent increase on grocery store spending in the “food, beverages, alcohol and tobacco” category after one year.
Also, eating out at restaurants and going on vacation (food, beverage and accommodation services), interest rates have essentially no impact on spending (and therefore likely prices). All the rate hikes so far would have only pulled down spending in this category by 1.6 per cent after a year, if it was similar to previous experiences in Canada.
Gas prices aren’t directly measured here but they make up about a third of the “operation of transport equipment” category, which also includes car repairs and other car expenses like insurance, parking and registration fees. Even here, the impact is small, with a decline in spending of 4.4 per cent across the entire category for the 4 per cent point hike in interest rates.
The broad conclusion of this research is that interest rates affect some categories far more than others. Certainly housing related spending is very affected. But the evidence shows that other prices, like grocery store foods, aren’t affected at all. Since you don’t buy food with a mortgage (or at least not yet), it makes sense that that type of spending isn’t impacted by interest rates.
Interest hikes soften housing, but boost other consumer prices
That was the historical evidence. Now let's look at how the Consumer Price Index (CPI) parts are changing in this rate cycle—particularly on housing, which was predicted above to be the most sensitive.
One thing the above data doesn’t examine is mortgage interest costs, which clearly are going to go up with the Bank’s raises in interest rates. Mortgage interest costs make up part of the CPI, and as they rise inflation rises. But this is offset by falling house and ownership transfer costs, like real estate agent commissions (captured in “other owned accommodation expenses” in the CPI), which will decrease inflation.
The knock-on effects on rent are significant and also not included in the data above. As interest rates rise, landlords can face higher mortgage interest costs and they try to pass these higher costs on to tenants in the form of higher rent. Tenants delay home purchases due to higher monthly mortgage payments and more people stay in the rental market, again driving up rent.
So you’ve got a balancing act: mortgage costs and rents rise with higher interest rates but house prices and ownership transfer costs fall and most other prices don’t change at all. So which side is winning? Figure 2 plots the factors out using the CPI data.
Rate hikes started in March, and those higher interest rates were “working” from May through September. That is, house prices and sales volumes were dropping faster than rent and mortgage interest costs were rising. In April, these categories, together, were adding 1.7 per cent to the CPI (which stood at 6.8 per cent that month). By September, they were only adding 1.3 per cent to the CPI (which then stood at 6.9 per cent).
The trouble is that by December 2022, all of these items combined were adding 1.4 per cent points to CPI, higher than in the summer. What changed in September is that rent, whose inflation was fairly stable, was now going up faster than ever, hitting 5.9 per cent year over year in November, the largest increase since July 1989.
As landlords pass on their higher mortgage costs to renters, it also means that Bank of Canada interest rate hikes on balance are driving inflation as of September, not slowing it.
If interest rates can just as easily cause inflation, what next?
Higher interest rates are just as likely to increase inflation as to decrease it. That’s what they’ve been doing since the fall of 2022.
Ideally, you’d want to decrease house prices and rent, but without the higher mortgage interest payments offsetting these declines. There are ways to do this.
For example, the federal government could say that real estate investors, who are buying upwards of a quarter of all residential properties, have to put far more money down than regular buyers for a mortgage, forcing many of them out of the market. The provinces could set up better rent control to keep rent increases affordable for tenants.
The feds could cancel Bay Street’s sweetheart tax breaks for Real Estate Investment Trusts, which buy up apartment blocks and jack up rent.
Further, the feds could drive massive construction in non-market rental units, long called for by tenant organizations.
These approaches could reduce house prices and rent, but without increasing mortgage costs. Unfortunately, governments have largely chosen interest rates as the tool and as we’ve seen, they can just as easily make inflation worse as better.
