No Rate change & Eitan’s Economic Summary

No Rate Changes: The Bank of Canada kept their overnight (Bank of Canada Prime) rate at 4.5%. This means that the Bank Prime rate is 6.70%.
*For some TD Bank variable rate mortgage holders, the TD Mortgage Prime is 6.85%.

On January 25th, the Bank of Canada (BoC) said they would hold rates steady and have a pause in any rate increase. They kept their word! Notwithstanding, the BoC maintains that they will raise rates again if needed.

Good news: Inflation numbers came out on February and we saw a decrease from 6.3% inflation (December) to 5.9% (January). This represented 8 straight months of inflation growth decreases. February numbers are not out yet.

However, Canada and the United States still have very high employment (labour shortages) which causes increases to wages, leading to spending, leading to price appreciation (more inflation).

The problem I’m seeing is that there are far too many competing forces vying to influence the BoC’s rate decisions. Legend: ↓ = reduce inflation | ↑ = elevate inflation

Surprisingly, due to our interest rates, Canada’s growth rate was actually 0% in Q4 of 2022. Unfortunately though, zero growth does not equate to lower inflation… We can easily have increases in the price of food and goods, even if fewer are sold. There is a tug-of-war here between price appreciation (due to wage growth) and decreases in demand (due to price appreciation). This is called a circular reference in excel… I think. Nerdy? Guilty as charged.

Overall, the BoC statements suggest that the economy is moving as forecasted, bringing the inflation rate down to the 3% mark in the middle this year. Most economists believe that the BoC will hold the rate steady, until there is a cut in rates in the first quarter 2024. There are a small few who think rates may be cut in late 2023.

Economic Policy Tools
Although the BoC is holding their rate unchanged at this time, there are three other economic policies Canada can use to reduce demand and curtail inflation: decrease government spending, increase tax rates (fiscal policy), and decrease the money supply through quantitive tightening (monetary policy).

There was some fiscal policy to get us out of the covid blues, but the majority was monetary. Huge sums of money were given out (CERB, CEBA, other covid handouts – no judgements here folks, just facts) and there were some tax breaks such as business-use-of-home coming from the fiscal/government side. However, more monetary moves such as increasing the money supply through quantitative easing, or the purchasing of bonds by the BoC, happened on a massive scale, causing our fixed rates to plummet.
If you locked in a sub-2% fixed rate, you got this rate due to quantitative easing.

At this time, the government isn’t going to stop spending and they are not raising our taxes; we’re left with monetary policy to get us out of this mess. And, since interest rates are not moving at this time, the government will continue with decreasing the money supply through quantitative tightening. Quantitative tightening is a major reason why we’ve had such large increases in the fixed interest rates over the past year.

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Bonds and Quantitative Tightening

Quantitative tightening is a monetary policy used to contract, or reduce, the balance sheet (assets) that the Bank holds.

The BoC can buy mortgage bonds from bond issuers (usually government organization likes CMHC), which increases the price of those bonds through supply and demand.

In the case of quantitive tightening, the Bank sells its mortgage bonds and since there are more bonds on the market for others to buy, the value of these bonds decrease (supply and demand).
As an aside, when the government sells bonds, they are asking for their money back (decrease money in the market) in return for offloading bonds on to the market.

I created the graph below to show how supply and demand works and because I love economics. The graph below is a basic supply and demand graph from 1st year economics (the only 1st year university class I got an A in) and it shows how an increase in the supply of something will decrease the price.

A bond has a coupon (return), an interest rate, and a value. What’s interesting about bonds is that the coupon, or return, stays the same. The interest rate and the value of the bond is what changes.

Coupon/Return = Rate/Yield x Price/Value

**Technically, the coupon/return, rate/yield, and price/value are all set out when a bond is created. However, bonds are purchased and sold afterwards, and what changes is the sale price. If the sale price changes and the coupon/return stays the same, then the rate/yield must also change.

So let’s take a $100 bond with a rate of 10%. The coupon here would be $10.

$10 = 10% x $100

Now, if the price of that bond decrease, to, let’s say $80, we would have to find R.

$10 = R% x $80

In this case, we divide $10 by $80, and we get 12.5%

$10 / $90 = R% = $12.5%

This is different from conventional thinking that values stay the same and as interest rates changes the return changes.

From our example above, and bringing it back into practice, the value of bonds has decreased, and since bonds are the foundation of our mortgage market, the interest rates we pay on fixed-rate mortgages has increased.

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Going back to the overnight rate by the BoC, the graph below is interesting… At this time, inflation (red) is still way above the BoC overnight rate (blue).

The BoC has already stated that they believe that inflation will go down to 3% by July 2023. And, since most economists assume no changes to the overnight rate (BoC Prime) in 2023, this means that our overnight rate will be quite a bit above the inflation rate for a while.

The BoC put the brakes on the economy starting in March of 2022, but inflation only started to decrease in July. There’s a few month lag in action and reaction.

I believe that once the overnight rate gets higher than the inflation rate, it will stay this way for a few months, or even half a year before the bank starts rate cuts.

In the 80s, during some of the worst periods of inflation, the BoC decreased rates too quickly, causing inflation to spike back up. where the BoC had to increase rates again a couple of time to stave off more inflation. I think the BoC will err on the side of caution and not decrease rates right away, even if there might be a good reason to do so (lower inflation).

No Rate change & Eitan’s Economic Summary

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