How High Can Interest Rates Go? (2019)

With 2019 well underway, we thought it would be beneficial to revisit a topic we talked about in 2018 (click here to read the 2018 post). The 2018 calendar year was full of volatility and economic ups and downs compared to recent years.

One economic factor that saw a lot of movement was interest rates. Dating back to mid-2017, there have been 5 interest rate hikes in Canada. The last rate hike took place on October 24, 2018. At this time we saw the overnight rate jump to it’s current level of 1.75%.

Every year, the Bank of Canada releases a schedule for interest rate announcements. For 2019, they have set a tentative schedule which includes 7 interest rate announcements (click here to see more on when announcements will happen).

The first of these announcements took place on January 9, where the Bank of Canada decided to hold its benchmark rate at 1.75%.

So, with 6 rate announcements left, what will happen to interest rates going forward in the 2019 calendar year?

It was originally expected that interest rates would continue to climb more steadily. But with some disappointing economic results nearing the end of 2018 (i.e., oil prices, weak wages, inflation), rate hikes have slowed.

Stephen Poloz’s goal was originally to get interest rates back to their neutral rate (2.5% – 3.5%). If interest rates are at their neutral rate, they would not be stimulating expansion or curbing growth.

This projection on rates being increased to their neutral rate was based on a Canadian economy that would have sustainable growth. However, as we know the last 3 months of 2018 saw a significant economic downturn.

One of the main reasons that central banks increase interest rates is to moderate inflation. The ultimate goal is generally to have inflation sit between 0% to 2%.

Note: Inflation and interest rates have an inverse relationship. As interest rates increase, inflation decreases, and vice versa.

From the perspective of inflation (0-2% inflation goal, and the inverse relationship), it seems odd that the BoC didn’t raise interest rates this week. The reported inflation rate for 2018 is 2.57% (projected inflation for 2019 is 2.23%). Significantly above the upper end of Canada’s goal of 2%.

Another reason that Canada would increase interest rates is to follow the US Federal Reserve. Although it is not official policy, the Bank of Canada does follow the Federal Reserve interest rate very closely.

One of the main motivating factors for following Federal Reserve interest rates are their effect on the Canadian dollar. If the US Federal Reserve increases rates, and the Bank of Canada does not, the Canadian dollar drops in value compared to the US dollar. This is due to, investors selling their Canadian dollars and transitioning into US dollars where more interest can be made.

However, the US economy is in a different situation. GDP growth is right around the 3% range since the Trump election, and wage growth has also risen to just under 3%.

The US Federal Reserve is under increasing pressure to continue modest interest rate increases to slow down the impacts of future inflation increases.

Based on the economic numbers, it is not unlikely that we could see interest rates increase in Canada this year. Raising interest rates slightly (0.25% – 0.5%) could help to slow the effects of inflation.

Based on the current situation in Canada, it is unlikely that the BoC will match all of the US rate hikes. For this reason, we could see the Canadian dollar weaken in comparison to the US dollar further this year.

In the end, it is almost impossible to predict exactly what is going to happen. The market is an emotional animal and the political situation in both Canada and the US have immense impacts on how this plays out.

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