Inflation Control and Mortgage Rates
If you’ve ever wondered how well the Bank of Canada does its job, check out this chart below from economist Sheryl King.
It shows the trend in Canada’s inflation level back to 1995 (when the BoC started using interest rates as a tool to achieve its 2% inflation target).
As the chart illustrates, inflation tends to stick near 2%. That’s thanks, in large part, to the BoC’s inflation control mandate.
Long-term, there is no reason to believe the Bank won’t be able to maintain this 2% trajectory. And the suppressing effect that could have on interest rates should be welcome news to Canadian mortgagors.
Of course, rates can and do spike in shorter time periods. Even though inflation ranges from 1% to 3% the vast majority of the time, there are wildcards and one of them is commodity prices. “(Commodities) are always a risk for headline inflation, particularly if global growth starts to reaccelerate,” King told CMT on Monday.
The BoC gets really concerned by inflation that’s outside of its 1-3% range. If price increases threaten to persist in the high 2%, or 3% range, for example, the BoC may aggressively raise rates until economic demand slows and/or supply catches up. But rates never keep going up. Over the past two decades, when inflation has exceeded one percentage point above target, the consumer price index (CPI) has typically come back down within three quarters (and mortgage rates have come down with it). A mature low-growth economy (like ours) and an aggressive inflation-targeting central bank are kryptonite to inflation. For that reason, it is highly unlikely that inflation would ever stay above the BoC’s 3% “control ceiling” for several years. Mortgage consumers can take some solace in that.
If long-term inflation continues at 2% as expected, rates cannot run up drastically and stay up. And in the medium term, some are even more dovish. King cites anIMF study saying, “getting prices back up to (the 2%) trend will require a lower policy rate” [italics ours].
All of this implies a reasonable risk level when choosing a shorter term (like a variable, 1-year or 2-year fixed)assuming:
You’re well qualified;
You can handle the potential risk of 20-30% higher payments (stress test your mortgage); and,
The difference between long- and short-term mortgage rates is sufficiently wide (e.g., when short-term rates are over one percentage point below long-term rates).
The above points are worth contemplating if you want alternatives to locking in for the long haul.
Other facts about inflation:
The most important measure of inflation is arguably “core inflation,” which measures the underlying trend in consumer prices. The Bank’s preferred measure of that is CPIX. CPIX has averaged just 1.6% in the past 5 years (well below the 2% target), notes King.
Inflation today doesn’t matter as much as inflation tomorrow. The BoC tries to project inflation 1.5 to 2 years out because that’s how long it takes rate increases/decreases to work their way through the economy.
Rob McLister, CMT