Neutral isn’t what it used to be—not with the Bank of Canada’s key interest rate anyhow.

In the modern era of monetary policy, the neutral policy rate (NPR) has averaged about 4.20%, according to BMO.

Today, BMO, TD, CIBC and others say it’s closer to 3.00%…or less. (Economists have lately been ratcheting down their estimates of the NPR.)

If you hold a variable-rate mortgage, the neutral policy rate matters. It partially addresses the question on every mortgagors’ mind:  How high could rates go?

A “neutral policy rate” refers to the Bank of Canada overnight rate that neither stimulates nor restrains economic growth. In other words, it’s the overnight rate intended to thwart excessive supply and demand and keep inflation near the Bank of Canada’s 2% target.

Over the long-run, the overnight rate should always revert back to the NPR, whatever the NPR happens to be.

If bank economists are right and the long-term NPR is in the 3.00% neighbourhood, it implies that prime rate will not exceed 5.00% for any lengthy amount of time. (Prime rate fluctuates at a spread of 2% above the overnight rate.)

Indeed, if the banks are accurate in their approximations of “neutral,” it bears well for variable rates.

Suppose, for example, you were considering the following two mortgage options:

• A 5-year fixed at 3.75%
• A 5-year variable at prime – 0.85% (2.15% today).

Assuming:

1. The overnight rate rose 200 basis points over the next 24 months as banks predict (so it converges with the 3.00% NPR); and,
2. You set your variable-rate payment to equal a 5-year fixed payment…

…then choosing the variable-rate mortgage would put you ahead (by about $135 over five years for every $100,000 borrowed*).

Keep in mind, Mark Carney says the overnight target doesn’t have to converge with the NPR, even if the economy is running at full capacity. That could be the case if “there are other [economic] restraints,” such as a strong Canadian dollar, says BMO economist Doug Porter.

If the NPR were instead ~4.20%, as it has been in the past, fixed rates would have a much greater chance of outperforming.

But today we’re in a new era, say economists. Many believe the coming economic reality (stodgy growth, high leverage, low ongoing inflation) won’t necessitate the rate increases of the past. That reality has steadily reduced the neutral policy rate, thereby lessening the risk of variable rates. In fact, variables have probably never been this good of a risk at the bottom of a rate cycle.

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* Assumes a 25-year amortization, a first rate hike in Dec. 2011, followed by three more 1/4 point increases, an eight-month pause, and four more 1/4 point hikes starting in December 2012. The timing of these increases is intended to roughly match up with the major bank’s published interest rate forecasts (which are subject to error and revision).

Note: Variable rate mortgages are a calculated gamble and not for everyone. Speak with a mortgage professional about your ability to handle rate increases that exceed the above forecasts.

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Rob McLister, CMT