The Catch 22 of low interest rates, fat debt

Some people want to know why the Bank of Canada would consider raising interest rates when high consumer debt levels are such a threat. Still others wonder why the central bank doesn’t just go ahead and do it to discourage borrowers from taking on more than they can handle.

The answer, of course, is that the Bank of Canada looks at a lot of things in terms of overall conditions and policy, notably its inflation target of 2 per cent

The central bank has been warning for months now that high consumer debt is worrisome, and very risky for those who can’t juggle the costs when interest rates inevitably rise further. Yesterday, a deputy governor at the Bank of Canada explained why, as one economist has put it, policy makers have left the pantry open while saying ‘hands off the cookie jar.’

Agathe Côté gave an audience in Kingston, Ont., a lesson in how low rates can juice a sputtering economy, by boosting lending and spending, and how that creates its own risks. But there, she warned, borrowers and their lenders should be the ones exercising caution.

“The bank recognizes that low interest rates, while necessary to achieve our inflation target, create their own risks,” she said. “Prudence on the part of individuals and financial institutions is the first line of defence against these risks. Supervision of financial institutions can also be effective in limiting excessive concentration of risk. The development and use of selected macroprudential tools constitute another line of defence.”

Household spending, representating about 60 per cent of demand in Canada, was crucial in getting the country out of recession, but now household finances have become “increasingly stretched.”

Ms. Côté noted, as others have before her, that household debt has surged at twice the pace of personal disposable income since the depths of the recession. It now stands at 148 per cent of disposable income. Coupled with low rates, rising house prices and home-equity loans have also led to the growth in credit, and, in turn, spending.

These high debt levels are now a threat. If things go south, a shock could spread through the economy.

“Some have asked if increasing interest rates poses such a threat to households, why raise them?,” Ms. Côté said. “Yet others have asked if household debt is such a concern, why not raise rates and discourage borrowing?”

The “cornerstone” of monetary policy in Canada is its inflation target. “In setting interest rates to achieve the inflation target, developments in household finances need to be weighed along with all the other factors influencing economic activity and inflation. Canadian monetary policy is set for overall macroeconomic conditions in Canada.”

Ottawa has already brought in stricter mortgage rules, she noted, and the Bank of Canada’s three rate hikes since the recession’s end have served as a reminder to borrowers that cheap money won’t last. That has started to have an impact.

“The BoC can only hope that its message is not being lost on deaf ears,” senior economist Pascal Gauthier of Toronto-Dominion Bank said after Ms. Côté’s speech. “At 148 per cent … and rising, the debt-to-income ratio is but one measure underscoring the need to pay close attention. By our calculations, economic and financial fundamentals suggest that a more sustainable debt-to-income ratio would lie around 138-140 per cent. Nonetheless, if debt grows in line with income, a policy response would not be needed. However, if debt outpaces income for another sustained period of time, targeted regulatory tightening may well be required to more firmly nudge households towards a more prudent path.”

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