What kind of shape would the federal and provincial governments be in if the cost of borrowing were two percentage points higher? writes Jack Mintz in the Financial Post. Below is an excerpt from the article which can be read in full here.
By Jack Mintz, May 6, 2021
It has been embedded in our psyches for over a decade that nominal interest rates are always low, even below inflation rates. Driven by expectations of continuing low interest rates, many people seem willing to bet the farm that their investments will bring them exceptional wealth. Such thinking is not just affecting the real estate and stock markets but also our politicians, including our minister of finance, who believes we should not worry about deficits as long as interest rates remain low.
In 2007, the Canada Pension Plan actuarial report assumed the long-run riskless real return on assets was 1.9 per cent, which, with two per cent inflation, implied a nominal bond rate of 3.9 per cent. Today we still think two per cent is the long-term inflation rate. But interest rates have fallen so far that long-term government bond rates have been below the expected inflation rate since the beginning of the pandemic. For example, the current yield for 20-year U.S. government inflation-indexed bonds is -0.6 per cent. Low interest rates are encouraging savers to seek high-yield investments like real estate, junk bonds and public offerings from (so far) profit-free unicorns. Borrowers, including governments, are accumulating mountains of debt.
With money so easy to borrow, it should be no surprise that low interest rates are one of the key factors leading to a surge in housing prices globally. According to the Economist magazine’s tracker, since the last quarter of 2015 housing prices are up: 32 per cent in the U.S., 22 per cent in Britain, 40 per cent in Germany, 20 per cent in France, 13 per cent in Australia and 31 per cent in New Zealand. We in Canada are close to the top, at 39 per cent. (It’s not quite true that the surge in prices is global: they have been flat in Italy and grown only a little in Japan and South Korea.)
Politicians are right to be concerned about people over-extending themselves by taking on large mortgages to finance their homes. While mortgage servicing costs are manageable at today’s low interest rates, a doubling in interest rates from two to four per cent increases 25-year monthly mortgage payments by almost 25 per cent (e.g., from $3,200 to $3,900 per month for a $750,000 mortgage). Triple the mortgage interest rate to six per cent (its value in the 1950s) and mortgage payments rise by 50 per cent.