The official rates of the Bank of Canada and the Federal Reserve are 0.25 and 0.08 per cent, respectively, whereas the 12-month inflation rates were 5.1 and 7.5 per cent in January.
In Canada and the U.S., the central banks were buying government bonds. This lowered longer-term interest rates and is called ‘quantitative easing.’ It is, in effect, a debt monetization process. Central banks print money to pay for the services they provide.
It’s obvious that citizens are losing money under this process, even after inflation is taken into account. Without quantitative easing, interest rates are normally close to or higher than the inflation rate. When quantitative easing wasn’t used, as in the 1970s, interest rates were near the prevailing inflation levels.
Recently, the Bank of Canada and the Federal Reserve said they’re were ending quantitative easing by not buying more bonds. As a result, the central banks are making long-term debt more costly, as other buyers must now buy the bonds and demand higher interest rates to do so. As well, both central banks say they will raise short-term interest rates.
This matters because a relatively small increase in the interest rates for bonds, especially when the rates have been very low, will substantially affect the prices of all assets, not just government bonds but real estate and share prices, too.
Bond investors and traders use a calculation called the bond duration, which is the present value of the interest paid on those bonds, usually paid semi-annually, and the final principal paid out when the bonds mature. For U.S. 10-year Treasury Notes yielding 1.875 per cent now, the duration is about 9.5 per cent, which means that a one per cent increase in interest rates will result in nearly a 10 per cent decrease in value. For 30-year Treasury Bonds, the sensitivity is about 22 per cent.
Of course, the stock and real estate markets, and mortgages, are extremely sensitive to changes in interest rates. Notably, the Bank of Canada’s overnight interest rate was 1.75 per cent two years ago and it is 0.25 per cent today. Were interest rates to return to the level they were two years ago, already a historical low, the rates would rise by about 1.5 per cent for short-term bonds and likely higher for long-term bonds.
If this happens, the bond markets could decrease by over 30 per cent. Stock markets wouldn’t be immune to this increase either. In fact, the changes that central banks have been making have already affected stocks in companies such as Shopify, Meta and Tesla. Yet investors still don’t seem to realize how badly things could change over the next few years.
If government policy doesn’t change, future home buyers may not be able to qualify for mortgages, which will result in lower demand for housing. Existing homeowners will then need to refinance their mortgages at higher rates.
Also, firms will likely reduce investing in their businesses and be less likely to hire more employees. When interest rates peaked in 1981, a severe recession occurred and unemployment exceeded 10 per cent. Unfortunately, thousands of businesses didn’t survive that recession.
The central banks are now playing catchup, having to raise their rates dramatically to match the inflation rate.
The failure of central banks to end quantitative easing and begin raising interest rates much sooner may be very costly to all consumers. If we’re lucky, the next few months may only bring stagnation and not a full-blown recession, but the odds are leaning towards the latter.
Ian Madsen is the senior policy analyst at the Frontier Centre for Public Policy.
© Troy Media
Troy Media is an editorial content provider to media outlets and its own hosted community news outlets across Canada.