The threat of another big hike in interest rates by the U.S. central bank had markets in a tizzy this week, but some critics worry that the bigger-than-expected increase won’t be enough to stop inflation.
Even as the market digested Wednesday’s extraordinary three-quarters of a per cent rate increase in the Fed rate, Federal Reserve chair Jerome Powell made it clear that interest rates are likely to go higher yet.
“Right now, our policy rate is well below neutral,” he said, referring to the theoretical balancing point where interest rates neither stimulate nor slow the economy.
Rates still a bargain?
“The federal funds rate, even after this increase, is at 1.6 per cent,” Powell told reporters at Wednesday’s monetary policy news conference, and he said that by the end of summer that could rise to between two and three per cent. “That’s still a low rate.”
Toronto real estate broker Frank Leo agrees.
Despite Wednesday’s Canadian real estate data showing a 13 per cent decline in average sale prices since February, Leo, who runs a successful team of agents under the ReMax brand, said the market has by no means dried up. And one of the reasons properties keep selling, he said, is that borrowing at current rates remains a good deal.
While it was the U.S. Fed that hiked rates on Wednesday, the federal funds rate directly affects the price of money in Canada too.
Leo said that if the interest rate remains below the neutral rate, real estate is still a seller’s market. And even after interest rates climb to neutral, he says, the market will continue to function well.
“That neutral rate or normal rate of interest is one that will allow the economy to grow at a good pace and still not, you know, slow it down,” he said.
As someone who makes his living in the real estate business, Leo may have a tendency toward optimism — but regional data shows that, even with rising interest rates, houses in the Toronto area are still in short supply.
Leo said there is currently about two months of inventory.
“When we get to five and six months, that’s when it’s balanced,” he said.
In many ways, Leo’s definition of the neutral rate is very close to the one offered by central banks.
According to the San Francisco branch of the Fed the neutral rate “is the federal funds rate that neither stimulates (speeds up) … nor restrains (slows down, like hitting the brakes) economic growth.”
Economic theory vs. the real world
That sounds pretty straightforward, but as Stephen Williamson, the Stephen A. Jarislowsky chair in central banking at Ontario’s Western University, said on the phone this week, it is anything but.
For one thing, said Williamson, like many economic concepts that sound simple in theory, determining the actual number in the world-as-we-find-it is difficult.
Both the U.S. and Canada currently peg the 2022 neutral rate at between two and three per cent, according to a recent analytical note from the Bank of Canada. But as Williamson described it, that solid-sounding number comes with a lot of caveats — and those caveats do not sound at all like the world we read about in our daily news.
Williamson painted a picture of that perfect world in which this theoretical neutral rate is supposed to occur. In it, “things have settled down so that, you know, the unemployment rate is about what it is on average, and the Bank of Canada is achieving its two per cent target,” he said. “The neutral rate would be the short-term nominal interest rate that’s consistent with all that.”
(Of course to an economist, “nominal” means the number without inflation.)
But in the real world not only do we have a labour shortage with a low unemployment rate, but we also have soaring inflation, partly due to the war in Ukraine and partly due to supply chain problems in the wake of the pandemic.
Time to buy a new stove?
When people are deciding whether to borrow or not, Williamson said, the important thing is not the nominal rate, but the real rate — in other words, the nominal rate after subtracting inflation.
So, if a borrower has a nominal interest rate of 1½ per cent, while inflation sits at 8½ per cent, the “real interest rate” — what the lender is earning from that loan while taking inflation into account — would actually be negative seven per cent.
Or as Williamson puts it: “Really low.”
In practical terms, one way to think about it is that if you have to borrow money to buy something today that you otherwise could not afford, say a stove or a car, at what is effectively a negative real interest rate — and the price of that thing is going to keep rising at the rate of inflation — it’s better to borrow and buy it now than to save up.
“If I expect this inflation to persist for five years, holy man, you know, that’s a good deal,” said Williamson. “I should be borrowing like crazy.”
As Powell explained on Wednesday, it was that disconnect between current interest rates and current inflation that persuaded the central bank to raise interest rates by an extraordinary three-quarters of a per cent this time and contemplate similar increases at future meetings.
While real interest rates remain a bargain now, Powell believes that by pushing rates to between three and 3.5 per cent by the end of this year, and as high as 3.8 per cent by the end of 2023, he can force inflation down. That, in turn, will lead to a positive real rate of interest.
With inflation still bouncing along at nearly nine per cent and signs of growing inflationary expectations, some analysts have called the Fed inflation-fighting assumptions optimistic. Others fear unneeded rate hikes will drive the economy into recession.
“There’s always a risk of going too far or not going far enough, and it’s going to be a very difficult judgment to make,” said Powell. “We’re quite mindful of the dangers.
“I will say, the worst mistake we can make would be to fail, which is not an option.”