How Far? How Fast? Getting Back to "Normal" Interest Rates: C.D. Howe Institute

TORONTO, May 29, 2013 /CNW/ - How far and how fast Canada's record-low interest rates will rise in the coming years is a vital question for consumers and businesses. In "The New "Normal" for Interest Rates in Canada: The Implications of Long-Term Shifts in Global Saving and Investment," authors Paul Beaudry and Philippe Bergevin find that the normal or "neutral" rate is likely lower than its historical average, and likely will remain at relatively lower levels over the next decade.

By any standard, interest rates in Canada and most other developed countries are very low, note the authors. Inevitably, interest 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.

Historically, the Bank of Canada's target rate averaged about 3.8 percent from the end of 1995, when the bank's current 2 percent inflation targeting framework was implemented, to the start of the last recession in Canada.  "Over a 3- to 10-year horizon, the normal or "neutral" rate for Canada is likely to be lower than the historical average of about 4 percent, due to fundamental shifts in domestic and world determinants of desired saving and desired investment," said Paul 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  babyboomers is edging towards retirement and, in the meantime, is increasing its saving level. Once the majority of this cohort enters retirement, they will start drawing down on their saving, but given the fact that the youngest babyboomers 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' 3- 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 2008-2009 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.

For the report go to: http://www.cdhowe.org/the-new-normal-for-interest-rates-in-canada-the-implications-of-long-term-shifts-in-global-saving-and-investment/21821

SOURCE: C.D. Howe Institute

Paul Beaudry, Canada Research Chair, Department of Economics, University of British Columbia; Philippe Bergevin, Senior Policy Analyst, C.D. Howe Institute; 416-865-1904; email: [email protected]