02/26/2014 05:44 EST | Updated 04/28/2014 05:59 EDT

Get Set for the Next Round of Rate Tightening

Nobody minds much when employment, GDP, leading indicators, confidence and other key growth-signals are up. But when 'up' starts to get in to the interest rate discourse, it's usually not so pleasant. After three-and-a-half years of ho-hum on this front, there is renewed interest in interest rates: where they are going, how fast, and what we need to do to be prepared, if change is indeed in the wind.

A lot of the talk is related to another 'up' that scares us: inflation. My last two missives talked about looming economic constraints, like labour supply, transportation infrastructure and industrial capacity, which suggest that rate hikes may be necessary to keep prices from getting out of hand. Another way of looking at the issue is that growth, a good-news story, is the catalyst. If growth, primarily of the global sort, is indeed returning, then current monetary conditions are clearly too loose to maintain price stability. Sounds like that is not a bad problem to have.

We can't be faulted for worrying, though. One can get used to low interest rates. Canadians have taken advantage of recent conditions, racking up a debt-to-income ratio of pre-crisis American proportions. Housing markets have been running well ahead of demographic requirements for years now, usually a sign of overheating. Higher interest rates in this context could have a stronger-than-normal impact on these sectors, which collectively account for 61 per cent of GDP.

We can worry, but we can also realize that policymakers are well aware of this reality, and that ensuring price stability doesn't imply nixing economic growth. Indeed, it may well prove advantageous that at the same time as global trade fires up Canadian exports, the domestic economy is slowing in a way that take some of the pressure off the labour force, transportation infrastructure and current industrial capacity -- which in recent years have shifted more to servicing domestic demand.

If the past is anything to go by, it's not a bad idea to look at how interest rate movements have played out. When we look at tightening cycles against subsequent loosening of policy, the most recent rate-hike phase ('05-'06) was both more drawn out and smaller in magnitude than the rate cuts that followed ('07-08). It is indeed the case if we follow rate loosening right through to their historical lows in 2009. The experience was very similar in the tightening of 1997-98 against the loosening in 2000-02. Tightening and easing cycles in the turbulent mid-90's saw sharp interest rate increases, but a protracted and further-reaching loosening cycle. Go back to the early, mid- and late-1980s, and the same is generally true -- loosening of nominal rates has generally outpaced rate-tightening.

This time around, things could be different, but the majority of recent rate moves tend to disagree. It is always difficult to see from the present vantage point how things will actually play out. However, it is instructive to know that tightening cycles have generally supported economic expansion periods, not aborted them. In Canada's current case, it is unlikely that growth will cause all of our economic cylinders to fire at once, suggesting a more normal tightening cycle than many may fear. Our forecast calls for short-term rate hikes to begin in early 2015, and to increase steadily through the near-term period, as evolving conditions warrant. We can debate the timing and magnitude of these changes, but what is clear is that long-term rates are already marching upward.

The bottom line? Talk of rising interest rates is very good news, since it strongly suggests higher confidence in near-future growth. It will increase the cost of funds, but it looks like, as in the past, we are likely to have the capacity to pass on and/or absorb the costs.


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