The Bank of Canada (BoC) raised its policy rate by 0.25% last week, as expected. This was the Bank’s first policy-rate increase since July 2023.
In its accompanying communications, the Bank justified the hike as a pre-emptive move. It warned that “cost pressures [tied to fuel prices] are building” and explained that raising now would “help reduce the risk that continuing high energy prices spread broadly to the prices of other goods and services.”
The BoC also expressed confidence in our economic momentum, assessing that “growth has picked up this year and is expected to recover further”. In his related commentary, Governor Macklem also asserted the Bank’s belief that stronger economic growth would raise the floor for inflation.
The BoC must be forward looking when setting its monetary-policy path, and it was always going to err on the side of hiking too early this time with the lessons from waiting too long post-COVID still fresh in the minds of its members.
The question that naturally follows for mortgage borrowers is: How many more hikes are in store?
To try to answer that, let’s begin with a look at where the BoC’s rate now stands:
As shown above, the Bank’s policy rate is currently 2.50%, one typical move below the mid-point of its neutral-rate range (which is defined as the range where its policy rate is neither stimulating demand nor restricting it).
The BoC considers anything below the 2.75% midpoint of neutral-rate range as still mildly stimulative, which is why Governor Macklem described last week’s hike as removing “monetary accommodation”.
If the BoC is worried that cost pressures are building behind the scenes, the first thing it will want to do is remove the last vestiges of policy-rate stimulus.
That makes the next hike pretty much a foregone conclusion. But the Bank’s emphasis on elevated uncertainty and its commitment to “proceed carefully” in its key closing statement decreases the likelihood that it will hike again at its next meeting in December.
Last week, economist Ben Rabidoux published this chart illustrating the Bank’s previous eight complete rate hike cycles. It shows that the median increase was 1.75%, the shallowest was 0.75% in 2010, and the deepest one was 4.75% in 2023.
If the BoC hikes by 0.75% this cycle, its policy rate will hit 3.00%, the top end of its neutral-rate range. Any increases beyond that point will push the policy rate further into outright restrictive territory.
Right now, the bond market is pricing in approximately four additional increases, which would take the policy rate up to 3.50%.
I think that forecast is too aggressive. It would risk significantly overtightening into an economy that is still in the midst of a trade shock.
The BoC can probably justify hikes to the upper end of its neutral range as a pre-emptive necessity, but I don’t see it hiking by more than that without our inflation data looking much different from today.
On that note, the BoC’s latest Monetary Policy Report (MPR) forecasts that our Consumer Price Index (CPI) will increase to 3.4% in Q4.
For reference, our CPI was 3.1% in September, but our CPI ex-energy was 2.1%, and the two key measures of core inflation the Bank has watched the most closely in the post-COVID era (CPI-trim and CPI-median) were both below 2%.
While the BoC is increasingly concerned about cost pressures mounting, it also continues to acknowledge that, thus far, there is little evidence that higher energy prices have caused more generalized inflation.
I appreciate the risk that businesses will start to pass on more of the cost increases tied to higher energy prices. But what if consumers can’t afford to pay them?
Higher energy prices act like a tax on other forms of spending, because borrowers can’t easily reduce their energy consumption. Workers can push for higher wages to recover their lost purchasing power, but our labour market is weak right now and average wage growth is slowing.
Simply put, inflation pressures are unlikely to rise sustainably if there is little to no pass through to wages, and there is little evidence of that thus far. (What we have seen instead is businesses absorbing much more of the cost increases tied to higher energy prices -and they have had room to do that with healthier than normal profit margins.)
The BoC’s forecast of higher inflation to come is also based, in part, on the expectation that our economy will continue to prove resilient.
It took all of two days for that assessment to be called into question. Its latest MPR forecasts our GDP growth in Q3 at 2%. But the actual GDP data, released by Statistics Canada last Friday, came in much lower than that. It lines up our Q3 GDP data at closer to 1.3%.
Circumstances can certainly change, and the BoC readily acknowledges that. The latest MPR uses the term “uncertainty” twenty-two times.
If the Bank is, in fact, going to take its policy-rate decisions “one meeting at a time” and there is “no predetermined path”, then the incoming economic data will tell the tale.
At this point, those data still point more toward a short, cautious tightening cycle more like the 2010 version, as opposed to a repeat of the aggressive cycle of hikes we experienced in 2022–23.
The Latest on Mortgage Rates
Government of Canada (GoC) bond yields increased immediately following the BoC’s rate announcement last week but then moved lower on Thursday and Friday as part of the flight to safety tied to the technology-stock sell off that dominated the headlines.
Fixed mortgage rates held steady, as did the discounts offered on variable-rate mortgages.
Variable-rate borrowers saw their rates increase for the first time in more than three years last week. Bond-market investors are now pricing in another three to four BoC rate hikes over the next year.
For reasons outlined above, I don’t think the BoC will hike its policy rate past 3% (the upper end of its neutral rate range). If I’m right, variable rates will peak at about the same level where most uninsured five-year fixed rates are currently offered.
My Take on Today’s Mortgage Options
Many of the borrowers I am currently working with are choosing fixed rates, and I can well appreciate the appeal of fixed-rate stability in our current volatile environment. I see the value of certainty in an increasingly uncertain world, even if it ultimately comes at a higher cost.
When asked for my take on whether a fixed or variable rate is more likely to prove cheaper, I maintain my view that today’s variable rates have the best chance to save borrowers money over their full terms.
Variable-rate mortgage rates increased last week and will likely do so again in the months ahead. But they will have to increase by a full 1.00% from here to reach the levels that are equivalent to most of today’s available fixed rates. I think that is unlikely.
Furthermore, if the current energy supply shock eases and inflation pressures along with it, the BoC will have room to reduce its policy rate if needed.
Variable-rate borrowers will benefit right away if/when that happens, but fixed-rate borrowers will have to wait for their renewal dates (and hope the interest-rate winds are at their backs when that time comes).
In these uncertain times, I think the odds (and the enhanced optionality) still favour variable rates.
Important note on potential risks when choosing between fixed and variable rates:
Insider’s Tip for Borrowers
If you’re in the market for a mortgage, instead of focusing on how much you can borrow, you will be far better off in the long run by focusing on how much you can (conservatively) afford to pay.
A lender doesn’t care if you never save for retirement, take a vacation, or go out for a nice dinner. With that in mind, when you decide how much you will borrow, focus on what payments work for your budget, not on the maximum amount you can borrow.
This post offers advice on how to work out a reasonable mortgage budget using two different approaches: the easy way and the hard way.
Three Posts Every New Visitor to My Blog Should Read:
1. Should Canadians Choose a Fixed or Variable Mortgage Rate During a Trade War?
This post provides a detailed comparison of the pros and cons of fixed- and variable-rate mortgages amidst trade-related economic uncertainty.
2. What Every Canadian Borrower Needs to Know About Fixed-Rate Mortgage Penalties
For myriad reasons, often unanticipated, many Canadians end up having to break their fixed-rate mortgages. This post provides a detailed explanation of the very different ways that lenders calculate their fixed-rate mortgage penalties. The amounts charged can vary significantly from lender to lender.
This post provides a detailed summary of the key terms and conditions to pay attention to in your mortgage contract. (These are not standard and can vary in important ways.)