As your local Kamloops mortgage broker, I am asked daily what the future of interest rates will be.

Canada’s inflation rate accelerated to 2.9 percent in May, an unexpected move. Financial analysts had been expecting the rate to ease to 2.6 percent. My response to any question about interest rates is it will depend on our economy. 

Bank of Canada(BoC) chief Tiff Macklem advised in his June 5 press conference Canadians shouldn’t “spend a lot of time thinking about the neutral rate.” 

Does Macklem realize you can’t have it both ways?

He spent months asking Canadians to help bring down inflation with increased interest rates. Rate increases centred around the neutral rate. Now, he’s telling them that this data isn’t something they should be concerned about.

What is the neutral rate?

• “An anchor” rate that’s “an important input for its economic projections.”
• “Used to gauge the stance of monetary policy.”
• It is an ongoing topic in BoC press conferences, speeches, annual assessments, working papers, interviews, parliamentary testimony, etc.

In other words, it’s important.

It’s crucial that the BoC estimates it regularly, publishes those estimates for all to see, comments on it in every Monetary Policy Report, and uses those estimates as a core reference rate for its rate modelling.

When rates go bonkers – sky-high or rock-bottom – the neutral rate becomes the North Star for navigating back to normalcy. It’s essentially the BoC’s GPS after a wild rate cycle.

But Canadians shouldn’t worry their pretty little heads over it. Just trust the experts, they suggest.

People often ask what drives Canadian mortgage rates. The answer—and this can’t be emphasized enough—is that Canada’s 10th-ranked economy is mainly subject to the whims of global rates, especially U.S. rates. That’s why the BoC’s rate-setting model relies on the United States’ estimated neutral rate, which the Bank deems “a proxy for the global neutral interest rate.”

A great way to gauge how close we are to neutral is to look at the 30-year bond yield. Canada’s 30-year bond yield is 138 bps below our policy rate. The BoC knows we’re nowhere near neutral despite its messaging. 

Here’s why borrowers should give a hoot about the neutral rate:

• The neutral rate influences the Bank of Canada’s rate decisions
• The overnight target always reverts to the neutral rate in time
• Neutral plus a conservative historical spread (e.g., +300 bps) has proven a reasonable stress test for mortgage payments
• Where the overnight rate sits relative to neutral, it affects the probability of success at a fixed or variable rate.

The further rates climb above neutral, the more variable mortgage rates outperform historically, and vice versa.

Of course, relying on the BoC’s neutral estimate for mortgage decisions does have risks. Relying on returning to the neutral rate doesn’t consider mortgage-specific factors (like the borrower’s 5-year plan, qualifications, etc.), and those always matter more.

If you have a mortgage coming due for a renewal in the next three months, let’s talk.

Source:(2024, July 3). Did Macklem Misdirect on the Neutral Rate? Mortgagelogic. https://www.mortgagelogic.new