It’s not often that a house is paid for outright upon sale, and as such mortgages are always front and centre for anyone purchasing a new home. It’s all about rates and terms, and has been for a good many decades now. So for those of you keeping a close eye on Canadian mortgage rates with the understanding of how they’ll affect your clientele and their buying power should pay close attention to new inflation data in Canada, providing plenty of clues about where our rates are destined to be in the near future.
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Heightened Uncertainty
Much of this inflation data will seem quite technical at first glance, but the overall trends are not difficult to spot. Last week showed that our overall inflation rate – as measured by the Consumer Price Index (CPI) – fell from 1.6% in September to 1.4% by the end of October. That’s scratching the bottom of the Bank of Canada’s (BoC) target band that sits at 1% to 3%, and well below the official 2% target. It would seem that inflation still isn’t pushing the Bank to raise its policy rate any time soon.
Within a mortgage-rate context, that means that variable-rate borrowers won’t likely see their rates rise over the near term, despite that being forecast. We’re also seeing subdued inflation taking pressure off Government of Canada (GoC) bond yields. These bonds determine how our fixed mortgage rates are priced.
Let’s first examine recent BoC observations about current inflation, and how the Bank is using monetary policy to manage inflationary risks through a period of heightened uncertainty. The interpretation of the inflation data by the BoC is more important than the inflation data itself.
The output gap is one of the key measures that the BoC uses to forecast inflation, measuring the gap between our economy’s actual output and it’s maximum potential output. As economic growth accelerates, the output gap begins to shrink and we eventually see a scenario where our economy’s resources outstrips its supply.
This results in rising costs, and the BoC would typically respond by raising its policy rate to slow economic growth and slow that inflationary pressure. Deciding on the right time to make that move isn’t easy, because our economy’s maximum potential output is not fixed and it’s not unlike trying to hit a moving target. Businesses invest in capacity expansion, technological advances improve productivity, and workers re-enter the workforce to change our maximum output capacities.
The Sweet Spot
Recent observations suggests that our economy is now hovering in an “inflationary sweet spot” where not only is the actual output expanding, but our maximum potential output is too. The significance of this is in the fact that it delays the closing of our output gap and extends our economy’s runway of non-inflationary growth. This sweet spot won’t be around indefinitely, but for as long as it is then the traditional correlation between growth and inflation won’t apply.
This current state of non-inflationary growth relieves the BoC of its concerns about needing to ease inflationary pressures in the near future. However, the Bank has repeatedly emphasized that it must be looking well ahead and into the future when establishing monetary policy. This may involve adjusting it pre-emptively.
So – if we’re trying to anticipate where mortgage rates are headed, an understanding of the BoC’s longer-term view will be required.
Here’s what they’re seeing:
- Wage costs, output potential, trade negotiations, and on the effects that the Bank’s two recent policy-rate increases are playing into our economic momentum quite strongly.
- The BoC’s monetary policy is “asymmetric” and geared to respond more aggressively to negative shocks than positive ones. The feeling is that it will be better to tighten monetary policy slowly as our economic prospects improve.
- The BoC is taking a patient approach because inflation has rested in the lower end of that 1-3% inflation target band for some time. Downside risks carry greater weight.
- There is concern that higher household debt is heightening the sensitivity of spending to interest rate increases. Add that to BoC’s belief that it can take up to twelve months for the economic impact of policy rate increases to be fully evaluated and it seems rate hikes aren’t likely to be considered again until 2018 is winding down.
Let’s now move to key data for this inflation analysis.
As mentioned above, CPI fell from 1.6% in September to 1.4% in October, and last year the BoC adopted three more technically detailed sub-measures called “CPI-common”, “CPI-trim” and “CPI-median”. Looking at each;
CPI–Trim is a measure of core inflation that excludes CPI components whose rates of change in a given month are located in the tails of the distribution of price changes. It allows for stability and doesn’t allow any single factor to pull at the overall picture. It was unchanged at 1.5% in October on a year-over-year basis.
CPI–Median plots the monthly percentage change in the price of each CPI item on a scale,then using the price change of the item at the mid-point of that scale as the CPI-median. This fell from 1.8% in September to 1.7% in October on a year-over-year basis.
CPI-Common is a measure of core inflation that tracks common price changes across categories in the CPI bundle, and it rose from 1.5% in September to 1.6% in October on a year-over-year basis. This suggests changes in overall aggregate demand, rather than sector-specific changes.
Summary
At least as far as the near term is concerned, the BoC’s belief is that our economy is currently in a favourable position where it can expand without promoting more inflationary pressures. When we look at this long term, the Bank advises monetary-policy caution, and that is ‘doable’ as long as inflation remains subdued. With this understanding, the consensus seems to be that both our variable and fixed mortgage rates will remain at or near today’s levels until we are well into the coming year of 2018.
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