Originally from our sister publication Advisor.ca.
The normal or “neutral” rate is lower than its historical average and likely will remain relatively low over the next decade, argue Paul Beaudry and Philippe Bergevin in a C.D. Howe Institute report.
By any standard, interest rates in Canada and most other developed countries are very low, note the authors. Inevitably, rates will go up and eventually return to more normal levels. In practice, however, there is disagreement about when, and by how much, rates should rise.
The authors provide guidance on where the Bank of Canada’s target interest rate should stand once the Canadian economy is back to normal and growing in line with its productive potential.
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Historically, the Bank of Canada’s target rate averaged about 3.8% from the end of 1995, when the bank’s current 2% inflation targeting framework was implemented, to the start of the last recession in Canada. “Over a three- to 10-year horizon, the normal or ‘neutral’ rate for Canada is likely to be lower than the historical average of about 4%, due to fundamental shifts in domestic and world determinants of desired saving and desired investment,” said Beaudry. “This is good news for borrowers, particularly the younger generation of Canadians, but problematic for savers, such as those entering retirement.”
The authors point to long-term shifts in global savings and investment that suggest the world equilibrium rate of interest will remain low in the next three to 10 years. Most notably, this is because desired saving, both domestically and internationally, is expected to remain high. In Canada, as in other developed countries, a large cohort of baby boomers is edging toward retirement and, in the meantime, is increasing its saving level.
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Once the majority of this cohort enters retirement, they will start drawing down on their savings, but given the fact that the youngest baby boomers are still under 50 years of age and that the retirement age is bound to increase, the bulk of this effect will not occur during the authors’ three- to 10-year horizon.
Possibly the most important long-term shift, they say, is the rise of China and the concomitant rise in its level of savings by households. Due largely to the lack of a western-style social safety net, Chinese households have a high level of precautionary savings. Further, the continued growth of the Chinese middle class, which typically saves a relatively high proportion of its income, is likely to contribute to keeping the country’s household saving rate at elevated levels.
The Great Recession of 2008/09 has also affected desired savings. As with similar past events, the fallout from the Great Recession is characterized by deleveraging, whereby households, businesses and governments are trying to reduce their debt levels.
“When the Bank of Canada starts gradually raising rates, it should raise them to levels below the historical average, according to our baseline scenario,” concluded Beaudry.