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Interest Rates are Rising

The Bank of Canada has kept its key interest rate (the target for the overnight rate) no higher than 1% since January 20, 2009. This is the lowest level since the Bank first opened its doors in 1935. The key interest rate has a significant influence on other interest rates, such as those for consumer loans, mortgages, rates offered on term deposits, and bond yields. Many borrowers have become used to obtaining credit at the lowest interest rates in modern times. This is about to change.

Inflation, the Silent Thief

The Bank of Canada aims to keep total year-over-year CPI inflation at the 2% midpoint of a target range of 1 to 3% over the medium term. They have been reasonably successful at meeting this target since adopting it in 1991. This means that official Government policy is to reduce the purchasing power of the Canadian dollar by 2% every year. In this environment something that costs $100 today will cost almost $122 in 10 years time or over $164 in 25 years.

Most people saving for retirement would like to think that every dollar they put aside today will be worth at least as much as that when they retire. Unfortunately, this is now very hard to accomplish. According to the Bank of Canada’s own data[1], the yield on one year Guaranteed Investment Certificates (“GICs”) is currently only 0.78%. If you are willing to tie up your money in GICs for five years, you do a bit better and receive a yield of 1.63%. Neither of these rates will allow the value of your money to keep pace with the official inflation target. Of course, investors can attempt to earn higher returns than that available through GICs by investing in riskier assets, but achieving those higher returns is not guaranteed.

Savers Will Not Lose Money Forever

History shows that periods of negative real interest rates (i.e., inflation higher than interest rates) are followed by periods of high real interest rates. This last occurred in the 1970s when the inflation caused by the OPEC oil price shock and Government deficit spending led to much higher interest rates in the 1980s.
Historical Bank Rate Image

There is no reason to think this scenario will not play out again, unless we are heading into a 1930s-style depression. Central banks everywhere seem determined to avoid that through cheap credit and money creation.

The Bank of Canada is keeping real interest rates negative because they want people to borrow and spend rather than save. They believe this will be helpful to the economy. While this may be true over short periods, it is becoming increasingly evident that interest rates at the lowest levels in recorded times are hurting, rather than helping, the economy.

Savers who are losing money in real terms are unwilling to consume now for fear of having no wealth later. Banks are unwilling to loan money to productive businesses at very low interest rates and companies themselves are unwilling to invest if they cannot foresee a reasonable return.

Timothy Hicks
Canso Investment Counsel

Timothy Hicks received his Chartered Financial Analyst designation in 1990. Tim joined Canso Investment Counsel in 2009 as a Vice President and Portfolio Manager. Prior to joining Canso, Tim served in various roles with Russel Investments, most recently as Director of North American Equity in their U.S. head office.