Why the Bank of Canada May Be More Hawkish Than You Think
For one view of Canada’s rate hike, consider the case of David and Neera. He can’t get a raise, is worried about retirement and they borrowed money a couple years ago to fix the roof. Interest costs will jump now, with vacations and kids’ clothes already out of reach.
Justin Trudeau’s entire economic agenda is aimed at David and Neera -- we know, because he invented them. Their story anchored the Liberal government’s debut budget, tying together the impact of all the prime minister’s measures. Now they’re a cautionary tale.
“Canadian families are also taking on more debt to make ends meet,” the 2016 budget said. “For David and Neera, this debt is a constant source of worry.”
The rate hike announced last week by Governor Stephen Poloz comes as Canadians grapple with record debt levels, and sets up potential friction with the government. Trudeau may not welcome Bank of Canada rate increases, given the pressure they place on the finances of middle class households, yet the prime minister’s own expansionist fiscal measures could force the central bank to hike more quickly to contain inflation that results from stronger growth.
Economists expect another rate increase by the end of the year, which would likely boost borrowing costs on everything from home and car loans to credit lines. A 2015 report from the Bank of Canada pinpointed those most exposed to higher rates: mainly younger, lower- and middle-income homeowners in some of the country’s most populous centers, not unlike the fictional David and Neera. Those regions also largely form the base of Trudeau’s political support.
The bank review focused on what it called “highly indebted households,” or those with a debt-to-income ratio of at least 350 percent. It found they made up 7.9 percent of all indebted households in 2012-14, up from 4.1 percent seven years earlier.
The share of total household debt held by the most highly leveraged Canadians rose to 21 percent from 13 percent, and mortgages now make up 87 percent of their debt, up from 80 percent. “Since real estate assets account for about 90 percent of these indebted households’ total assets, their net worth could be particularly affected by a house price correction,” the bank found. The situation of the highly indebted could also “change materially in an environment of rising interest rates.”
Financial Stability
The Bank of Canada reported last month that, for insured mortgages, the proportion of highly indebted borrowers -- defined in this case as those with loan-to-income ratios greater than 450 percent -- rose to 17 percent nationally in the first quarter 2016 before declining to 10 percent a year later. The central bank pointed to tightened mortgage eligibility rules as the cause of the decline. However, the changes probably contributed to the growth of uninsured mortgages, which the bank flagged as a potential risk to financial stability.
Highly indebted households are on the front line of any rate-hike impact. The growth in such cases skews younger, less-educated and to the middle of five income quintiles -- decidedly the middle class on which Trudeau stakes his brand. They tend to live in Alberta, British Columbia and Ontario, the latter two of which include vote-rich Vancouver and Toronto, whose hot housing markets have been targeted by policy makers hoping to avoid a crash. Indeed, values have slumped of late, though mortgage delinquency isn’t yet a problem.
Benjamin Tal, deputy chief economist at Canadian Imperial Bank of Commerce, argues that -- at least for now -- the risks of rate hikes in a strong economy don’t pose credit quality concerns, but the risk of “policy overshooting” by the bank is higher than before the 2008-2009 recession. While the total value in outstanding mortgage loans has grown, the number of borrowers has remained relatively stable and they are so far behaving well, he said in a research note Wednesday. Nevertheless, “increased sensitivity to higher rates will prevent the bank from moving too rapidly.”
Electoral Math
Trudeau’s electoral base overlaps largely with these at-risk borrowers. Compared to his national result, he drew disproportionately high support in Toronto and Vancouver, and in Ontario overall, but lower-than-average support in Alberta and British Columbia, polling conducted by Abacus Data after the 2015 election shows.
The Liberal leader was popular among younger voters -- beating the rival Conservatives in every age group under age 65. However, the Conservatives outperformed their own national result among those with high-school education or less, a group over-represented in the new crop of highly indebted households. Abacus found the Liberals and Conservatives tied among that cohort.
Trudeau’s support has shifted somewhat since. His Liberals now have support of 31 percent of voters with a high school education or less, compared with 40 percent for Conservatives, according to a poll conducted in June by the Angus Reid Institute. Trudeau continues to hold a commanding lead among younger voters, the survey found.
‘Amplified’ Impact
Trudeau and Poloz won’t clash immediately. Stephen Gordon, an economist at Laval University in Quebec City, said any tension would be two-fold: Poloz might have to tighten more quickly because Trudeau’s deficit agenda is adding more money into the economy, and a faster pace of rate hikes could also magnify costs for the heavily indebted.
“This could mean that the consequences for highly-leveraged households would be amplified,” Gordon said in an email. “I don’t think we’re anywhere close to a narrative in which middle-class households are going bankrupt because Justin Trudeau’s government is spending too much. But it’s something to keep in mind over the next couple of years.”
The middle class, and its spending power, is core to Trudeau’s agenda. Among his first moves was a tax cut for middle-income earners and a hike for high earners. Speaking this month at the Group of 20 summit in Hamburg, the prime minister said that wasn’t “out of class warfare or envy or anger,” but rather because when the spending power of the middle class jumps, “businesses have more customers, society is more stable.”
Morneau’s Message
Trudeau’s finance minister, Bill Morneau, has sidestepped questions about rate increases and focused instead on economic growth, saying Canada leads the Group of Seven partly because of the government’s measures. He dodged a rate question again Tuesday during an announcement of tougher tax rules for the rich.
“Canadians as a whole are more resilient than they were a year ago because of the improvements in the economy,” he said, conceding that interest rates will change borrowing behaviors. “It is playing out largely the way we thought it might.”
And yet, early last year, David and Neera’s tale in his debut budget document hinted at a forthcoming tension with the country’s central bank.
“The more that families owe, the harder it is for them to save and plan for their future. As a result, more and more middle class Canadians like David and Neera feel that they are working harder than ever, and not getting any further ahead.
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