William Watson: Raising real interest rates will be hard work

One thing is certain: 1% for the overnight rate will not be enough

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At least six months late, the Bank of Canada finally began raising interest rates. Its key rate—its target for the overnight market rate—is now 1.00%. Last year, at the same time, it was 0.25%. It rose to 0.5% in March and 1.00% in April. Half a percent a month for the rest of the year would put it much higher than it has been in recent years, although no one is predicting that.

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Of course, few of us (I suspect) are large financial institutions that lend each other multi-million dollar overnight loans. Overnight interest is therefore of little practical interest. Fortunately, the Bank of Canada also tracks the “Effective Weekly Household Interest Rate,” which is a combination of various rates, including mortgage rates. It is currently 3.64%. This week last year, it was 2.56%. So that’s up 108 basis points or just over a percentage point.

But there is also a thing called the rate of inflation. Last March, it stood at 2.2%, just a little above the Bank of Canada’s target. In March, it was 6.7% – way, way above target.

So: interest rates have gone up a bit but inflation has gone up a lot. This means that despite the bank’s monetary tightening, real interest rates have risen down. “Real interest rates” sounds deeply philosophical. “What does it mean to be ‘real’?, asked the metaphysician. In fact, real interest rates are simply regular interest rates adjusted for inflation – although the idea is simpler than the actual calculation. Borrowers and lenders presumably condition their behavior on what happens during the term of the loan to the value of the money involved, so ideally we would adjust the agreed interest rate for inflation as each side of the deal expected over the term of the loan – which of course they are unlikely to reveal, either to each other or to government statisticians.

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Instead, the quick and sloppy way to calculate real interest rates is to subtract the rate of inflation. Last spring, using the figures mentioned above, an interest rate of 2.56%, minus inflation of 2.2%, meant a real interest rate of 0.46%. This spring, an interest rate of 3.64% minus inflation of 6.7% gives a real interest rate of -3.06%. Despite the bank tightening, real interest rates are at 352 basis points lower than they were last year at this time and they are noticeably negative.

Non-economists often find it ironic that raising a price – the interest rate, which is the price of borrowed money – fights inflation. It does this by discouraging borrowing that helps finance consumption and investment that fuels inflation. But you have to think that what matters are real interest rates, not “nominal” (the economists’ antonym for “real”). And when inflation has taken off, raising real rates can be a lot of work.

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Reports of rising interest rates, like reports of rising house prices, suggest that they hurt everyone. But that’s only because reporters only talk to borrowers for stories about interest rates and to potential buyers for stories about home prices. In fact, lenders are more than happy to see interest rates rise, and owners are rarely opposed to an increase in the value of their primary asset.

In both groups these days, you’ll find plenty of baby boomers. In fact, a new paper by Joseph Kopecky of Trinity College Dublin and Alan M. Taylor of the University of California (Davis) argues that baby boomers are largely responsible for the real interest rates that have been so low in recent years. Their diary has a very colorful subtitle: “The Annuitant’s Murder-Suicide.” Rentiers, in the economic tradition, are people who cut bond coupons for their income – the kind of people who populate British costume dramas of the Masterpiece Theatre. In 1936, John Maynard Keynes, himself a Tony Brit, argued that once the Depression was over, the rising incomes and savings rates that economic growth would bring would lead to the “euthanasia” of these rentiers. , because all the extra capital drove down interest rates.

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Today, Kopecky and Taylor argue, even more grimly, that baby boomers are doing it to themselves. How? As people age, their appetite for risk decreases. Yes, investing in the stock market brings higher average returns. But the market is subject to sickening ups and downs. People get to a certain age and they’re happier with a lower yield that doesn’t fluctuate as much. But with all these older baby boomers putting all their money into safe-yielding asset markets, no one is borrowing from these markets to pay much. Real rates therefore remain low.

Rising real rates are what will tame inflation. But inflation makes it harder to raise those rates. So will the strong preference of baby boomers for safe assets.

One thing is certain: 1.00% for the overnight rate will not suffice.



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Maria D. Ervin