Ordinarily there’s not much interesting about interest rates.
If things are functioning as they should, most of us rarely think about them. Anyone who does bring them up soon finds it’s a surefire topic to make a dinner companion’s eyes glaze over.
But when they do get interesting, it’s rarely a good news story.
Just ask someone who bought a house in the second half of 1981, when a five-year fixed mortgage rate was above 21 per cent. At the time, the average house price in Canada was $72,500. With a 10 per cent down payment, that made for a monthly payment of $1,206, when the average monthly pre-tax wage was $1,765.
I’m willing to bet those folks found interest rates not just interesting, but terrifying.
The ones who found them horrifying were those who bought in 1976, when five-year mortgage rates were less than half the 1981 rate and they were finding, upon renewal, that their monthly costs were unavoidably skyrocketing.
This is of interest today because we find ourselves at the opposite end of the spectrum, where interest rates have been unnaturally low for a long period of time. They’ve been held artificially low since the turn of the millennium by central bankers in an effort to stimulate economic activity and prevent serious downturns.
- Read more: Low interest rates a risk too
From the dot-com bust to the 9/11 terror attacks — and President George W. Bush’s famous exhortation to fight terrorism by going shopping — the conventional wisdom has been to keep interest rates low, the money taps wide open, hoping all will eventually be well.
That only accelerated with the U.S. housing bust and the global financial crisis that followed. In the wake of that economic heart attack, many central banks, including the Bank of Canada, undertook a zero interest rate policy. That’s when the interest rate is lower than the rate of inflation, essentially rewarding spenders and punishing savers.
To a farmer or business owner, these rates can look like a great deal. After all, they allow a business person to make investments, which enable them to grow and become more efficient, without paying a prohibitive price for it. Hidden under the surface, however, is some real risk.
The economic term for what happens is mal-investment. People get lulled into thinking that this cheap money will last forever, and they go out and spend themselves into a really precarious position. Right now Canadians are carrying a record debt load, relative to incomes, of 167.6 per cent, according to a Statistics Canada report issued in September. To put that into perspective, at the height of the U.S. housing crisis in 2008, Americans were carrying debts that equalled 147 per cent of their annual incomes.
The clearest example of this playing out is the Canadian housing market, where pretty much everyone can tell you a tale of a young couple with no money who rushed out, loaded up on a huge mortgage, and bought a nicer first house than their parents wound up with in the end.
It’s not that these young folks are stupid. They’ve never known anything but low interest rates and rising house prices. And at least for now, their bet seems to be paying off.
Just this week Bank of Canada head Stephen Poloz told Canadians that rate is staying unchanged because the economy is on life support and the world seems stuck in a low-growth pattern for the foreseeable future. But at the same time, he warned Canadians to approach low interest rates with extreme caution. What goes down can go up, and when it does, the overly indebted could be in for a real shock.
This very risk is what’s led the federal government to introduce a range of policy changes, mainly through the Canadian Mortgage and Housing Corporation, that aim to prevent this, such as stress testing borrowers at a higher interest rate.
The risk isn’t confined just to the housing market however, it also extends to businesses — including farms — that could be lured into making investments that might otherwise not look so attractive. Rising interest rates would give the heavily indebted farm some real cash flow issues.
That’s why FCC’s chief economist, J.P. Gervais, has added his voice to the chorus calling for caution.
He’s advising farmers to exercise caution, to consider the size of the financial obligations they’re taking on, and to pay close attention to the tried-and-true rules like debt ratios that have unfortunately started to seem like quaint relics. It’s all sound and prudent advice.
In fact FCC has voluntarily taken a number of the steps that CMHC is now being forced into. For example it’s required that loans be “stress tested” at a higher interest rate for the past six years as a formal policy. Informally, it’s applied those standards on its largest loans for close to a decade.
If interest rates do get interesting again, farmers will be glad they heeded this sage advice.