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:
- The overnight rate rose 200 basis points over the next 24 months as banks predict (so it converges with the 3.00% NPR); and,
- 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.
* 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.
Rob McLister, CMT
Great article Rob. Are you sure about the numbers…“by about $135 over five years for every $100,000 borrowed*.“ Could you put a scenario with a mortgage amount.
Thanks
Kristina
Thx Kiki,
The numbers are based on the assumptions noted. If you want to email me, I can walk you through some scenarios.
Cheers…
RM
Should the rates rise to the neutral point, they may not stop there. You could also say that prime rates should not be much lower than 5% for any extended period of time but then special situations come up like the last few years. The mirror image of that could be prime rates of 6-8 percent over a 5 year period (and it can go up a lot further than it can go down now).
It’s easier to tell a story than to actually predict the future, but if you want to know what could cause a rise in interest rates you could look at growing commodity demand from developing countries causing global inflation even with low growth in north america, which might lead to higher interest rates to control inflation even if it hurts growth too. Maybe the core inflation is understated and the headline inflation is an early warning. The central banks might even act early to prevent a repeat of past experiences in the 70s. Wow, it’s easy to sound like an economist :)
Economic cycles often overshoot in both directions, and we probably spend much more time with interest rates above or below average than at the average. But there are too many variables to make a reliable prediction; it’s good to be aware of possible scenarios but not focus too much on any one of them.
Hi Richard,
Thanks for posting. This is a great comment because it allows for reinforcement of some key points, namely that:
* The neutral rate is theoretical.
* The overnight rate can exceed the neutral rate as noted, but by definition, must always revert back to it.
* “Special situations” do come up and the neutral rate does change over time. If we revisited this story in 10 years the neutral rate could be somewhat higher or lower.
The inflation and rate picture that you paint is always possible. For that matter, any rate change within reason is “possible.” The question to be asked is: Based on all available information today (including the BoC’s 2% inflation target, long-term inflation trends, foreign trade balances, etc.), how probable is a 7-8% prime rate? Most analysts would state “not very,” at least in the next five years.
Homeowners, while considering their risk tolerance and financials, can choose to bet with those odds or against them.
The takeaway from all this is that economists and policy makers believe that that overnight rate (and hence prime) doesn’t have to increase as much as it once did. One can draw any line in the sand when projecting the upside for rates. This 3.00% neutral rate is merely the financial community’s educated and approximate long-term consensus for the theoretical “average” overnight rate. (What a mouthful!)
Cheers…
Rob
World economies headed for slowdown:
http://economictimes.indiatimes.com/news/international-business/major-economies-heading-for-slowdown-oecd/articleshow/9185406.cms
IMHO global inflation is a fantasy unless the world’s biggest consumers (US, UK, EU, Japan…) throw up blockbuster GDP numbers. That isn’t going to happen anytime soon.
great article rob….
so for those of us who dont have a degree in economics what you’re saying is that — given the uncertain world conditions with the u.s. deficit, greece, etc — there has never been a better time to ride the variable pony, as long as one doesnt assume the low rates will last forever……
Thx np,
Variable rates are generally most risky just after the bottom of a rate cycle. (We’re 75 basis points above the bottom now.)
Despite this fact, if you polled the top economists, their consensus would be that rates don’t have to increase as much today to slow the economy and contain inflation.
That and global uncertainty suggest the odds of a variable outperforming a 5yr fixed are better than they usually are at this stage of the rate cycle.
Folks who are willing/able to make an educated bet on a variable mortgage should nonetheless prepare for contingencies (i.e. higher than expected rates). One way people can do that is by assuming a 3% increase in prime rate and stress testing their budget.
Cheers…
Rob
Exceleltn article and great comments. What a relevant topic!!! Thanks for always keeping us in the loop and bringing added value!