We are now nearly 10 months through 2022 and it has been a rough year when it comes to all things finance. Investment markets have faced headwinds. As of this writing, the TSX is down 7.4%, S&P 500 is down 16.6%, Dow is down 9.3%, and NASDAQ is down 25.6% year-to-date. Inflation passed decade highs and is still well above targets.
In addition to markets being down and inflation being high, many people are worried about food and energy shortages. Energy shortages are of particular concern in parts of Europe. However, even our neighbors south of the border only have 25 days of diesel reserves. This is the lowest level since 2007.
We also had an interest rate announcement in Canada this week on October 26. The next US rate announcement is scheduled for next week.
There are a lot of contributory factors to the current economic landscape: rising energy costs, supply constraints over the last two years, political unrest and war in Ukraine, and the upcoming mid-term election in the US.
We want to take some time and look at current interest rates and inflation in Canada and where they are expected to go. At the end, we also talk about the current government and consumer debt.
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Canadian Interest Rates
We have talked a lot about interest rates. They are a very important economic variable that affects most Canadians. Interest rates are used to control economic activity. Interest rates are supposed to have an inverse relationship with inflation.
This means if inflation is too high, central banks will raise interest rates to lower inflation. On the other hand, if inflation is too low, central banks will lower interest rates to try and spur on the economy.
For more information on interest rates check out Rising Interest Rates Are Crushing Variable Mortgages.
This week, the Bank of Canada raised interest rates to 3.75%. Another 50bps increase. This was less than the expected 75bps, as prior to the announcement the consensus seemed to be that rates would be increased to 4%.
In the 2022 calendar year, interest rates have increased by 3.25% and we might not be done yet. Prior to the most recent rate hike, forecasters were saying rates would rise to 4.25% by the end of the year in Canada and 4.5% in the US. The US has its next rate announcement next week. So we will see what comes of that.
Due to the lower-than-expected rate hike this week, it looks as though forecasts have been revised down. The peak now looks like it will be 4% by the end of the year, meaning we should expect a 25bps increase at the December announcement. There are also currently no rate hikes expected for 2023, and in fact, rate cuts could be the reality.
Canada is now the second central bank, Australia being the first, that has raised rates less than expected. It will be interesting to see what the Federal Reserve in the US does on November 2. As of the time of this writing, the US interest rate forecast is expected to be 4.5% by the end of 2022 and peak at 4.75% in 2023. This is still a significant increase from the current rate of 3.25%. Will the Federal Reserve also “soft pivot” and slow down the rate at which they raise rates? We will have to wait and see.
Inflation has been one of the biggest talking points of the year. Understandably so. There is not a single reported category within the Canadian CPI that has gotten cheaper over the last 12 months. However, the last couple of months has shown that we may be on the right trend to getting inflation back under control.
In September there were several categories that saw a price decrease compared to August; transportation and energy being the two most noteworthy ones. However, year-over-year they are still up 8.7% and 14% respectively. Will we see prices go back to where they were prior to the inflation spell? That is extremely unlikely, especially in the short term, and would require a period of deflation.
As hinted, the September inflation report showed annual inflation dropping to 6.9% from 7.0% in August. Although not a monumental drop, it is a drop nonetheless. That marks the third month in a row where inflation has been reported lower.
Although the annual reported inflation dropped, it is important to note that the month-over-month change was still positive (0.06%) in September. Whereas, the August report saw the month-over-month inflation drop (-0.3%).
We all know that central banks and governments are targeting a 2% inflation rate. We also know that we have been running significantly above that for a while now. When will we get back down to that target?
Forecasters believe that we could be down to a 2% inflation target in Canada by the end of 2023. Some forecasts even have Canada getting as low as 0.8% annual inflation by Q2 2023. That seems like a very steep drop, potentially due to recession fears.
Maybe this is the reason that the bank of Canada didn’t raise interest rates as much as expected. Maybe they see that we are on the right course and we will reach the target inflation with fewer rate hikes than previously thought. Or, perhaps they are worried about the stability of the economy and do not want to push it into a deep recession by raising rates at the previously anticipated pace.
Looking to the end of the year, it is currently believed that inflation will finish the year at ~6.4%. That doesn’t sound like a large drop. However, to achieve this, inflation would have to average monthly increases of 0.1% for the remaining three months. To put that into perspective only six months have been at or below that rate since March 2020 (31 total months).
Debt to GDP
When looking at the economic condition of a country, an important figure is a Debt to GDP ratio. The debt to GDP ratio compares a country’s public debt to its gross domestic product. It is a figure that predicts the country’s ability to repay debt. It can also be looked at as how many years it would take for a country to pay back its debt if all GDP was directed to debt repayment.
Canada’s debt-to-GDP ratio has taken a significant hit:
A similar stat but on the consumer side of things is the household debt to disposable income ratio. Which has also seen increases, granted not nearly as drastic:
So why am I bringing this up? Well, the last time interest rates were this high, both government and personal debt obligations we much lower. Government debt to GDP was 30% lower in 2009 (last time interest rates were this high), and consumer debt to disposable income was roughly 18% lower. This means both government and consumers are feeling the increased costs of debt obligations with rising interest rates.
If interest rates stay high, and government revenue doesn’t increase they could push themselves into a debt spiral. Meaning, the only way to meet debt obligations is by printing money, but that will devalue the currency potentially forcing government (and citizens) to take on more debt. In turn, forcing the government to print more money… etc., etc.
It is also interesting to note that since the last recession in 2008 both personal and government debt never declined to pre-recession levels. Even as the economy rebounded. In fact, both governments and consumers just seemed to leverage up more.