The terms “inflation” and “interest rates” were inescapable in 2022 and will likely continue to be prolific throughout 2023 as the measures to combat inflation last year have yet to accomplish the desired result. Though most people have a general understanding of these terms separately, it’s how they relate to each other and affect the economy that’s often unclear. Even less clear are the ways you can protect your financial future during these turbulent times.
Before exploring the relationship between inflation and rising interest rates, let’s delve into each term separately.
What is inflation?
In relation to the economy, inflation is the increase in price for goods and services. There are many factors that affect prices including the cost of labour, materials, and how difficult a product is to find. Basically, inflation is caused by too much demand relative to supply.
Though there is some debate as to the exact causes of 2022’s inflation, economists generally agree that the pandemic shifted demand away from services toward goods, which left producers unable to keep up with demand. Factory closures reduced supply just as demand was rising, which sent prices up even further. The Russian invasion of Ukraine caused an increase in oil prices, which increased the cost of both manufacturing and shipping, while also forcing up the price of other commodities. These factors, coupled with global labour shortages, left businesses unable to meet the rising demand. Record-low borrowing rates in 2020 and 2021, as well as a supply constraint due to underbuilding, gave rise to a significant annual increase in single-family house values and rental prices as demand was greatly outpacing supply.
How is inflation measured?
Inflation in Canada is measured every month by Statistics Canada. They track the price of a list of goods and services referred to as a representative “basket,” the contents of which reflect how much Canadians typically buy of each good or service across eight categories. The average price of these items is considered by the Consumer Price Index (CPI) which measures price change by comparing the cost of the basket through time. When the monthly CPI figure is released, it compares that cost in a given month with the same month a year ago.
According to the Bank of Canada, Canadians don’t usually have to pay much attention to inflation. “That’s because inflation in Canada has been close to 2% per year for the past 25 years or so.” To accomplish this, in 1991, the Government of Canada and the Bank of Canada (BoC) agreed that it would be best for Canadians to have predictably low and stable inflation. This agreement made it the responsibility of the BoC to bring inflation down to about 2% then keep it within 1 to 3% thereafter. We have been above their target of 2% since March 2021. In December 2022 the CPI figure rose 6.3% year over year, following a 6.8% increase the previous month.
Why do interest rates matter?
Interest is the cost of borrowing money. Interest rates influence borrowing costs and spending decisions of households and businesses. Lower interest rates, for example, would encourage more people to obtain a mortgage for a new home or to borrow money for a car or for home improvement. Lower rates also would encourage businesses to borrow funds to invest in expansion such as purchasing new equipment, updating plants, or hiring more workers. Higher interest rates would restrain such borrowing by consumers and businesses.
When it comes to interest rates, Canadians are divided into two categories: Net Savers and Net Spenders. Net Savers invest primarily in interest baring securities like GICs and bonds and prefer high interest rates as it means better returns, while Net Spenders borrow money to buy homes, cars, businesses etc. and prefer investing in non-interest baring securities, like common stocks, and want the lowest possible interest rates as it costs them less to borrow.
Why interest rates change
There are several factors that cause interest rates to change. These include rates of inflation, market forces, the BoC’s monetary policy and the supply and demand of money in the economy. Short-term interest rates are driven by the decisions made by the BoC while long-term rates are driven by market participants who are trying to determine future economic conditions.
The BoC’s main role is to set the bank rate, or overnight rate, which is the starting point for the “prime rates” set by financial institutions and lenders. Lending is a business, and a mortgage is just another product you buy that’s designed to generate a profit. Lenders need to cover their operating costs and as well as the risk that the loan won’t be repaid. There are two types of mortgages: variable and fixed. Variable mortgage rates are tied to lender prime rates, which are directly affected by the bank rate, while fixed mortgage rates are mainly influenced by BoC bond yields and changes in the bond market.
Increasing interest rates during times of inflation
One of the methods the BoC uses to bring down inflation is by raising the bank interest rate. When interest rates increase, it triggers a series of events. Higher interest rates discourage people from borrowing money because it will cost them more and prompts them to save or invest more instead. This results in people purchasing fewer goods, which lessens demand and slows business growth, share prices and eventually the whole economy. Rising interest rates will also increase loan payments that consumers make on variable rate loans leaving them with less money to purchase goods or services
With inflation rates not seen in nearly four decades, the BoC rapidly increased the bank rate seven times from 0.25% in March 2022 to 4.25% in December 2022 in an effort to curb inflation. The effects of higher interest rates have been working their way through the Canadian economy, with June’s inflation high of 8.1% brought down to 6.3% in December.
Predictions for 2023
As reported in the Financial Post, BoC Governor, Tiff Macklem, has said he will do what it takes to get inflation down to 2%, and that means interest rates are likely to go higher still. Meanwhile, Douglas Porter, Chief economist at BMO stated that “We believe the main story is that there will be no scope for rate cuts in the year ahead, and that central banks will maintain these relatively high rates until underlying inflation is truly cracked — and that process will take time.” BMO predicts at least one more interest rate hike this year and consumers shouldn’t count on interest rates coming down at all in 2023. Most private sector forecasts in Canada now assume there will be some kind of a recession in early this year.
How Equiton can help
With increasing interest rates and high inflation, investing in a private real estate investment trust (REIT) is one way to potentially play defense for your portfolio and protect your financial future. Private Canadian Apartments1 haven’t had a negative annual return in the last 35 years, including during the last two recessions. This is because residential real estate is a necessity. Everyone needs a place to live. Multi-residential properties, like those in Equiton’s Funds, generate consistent monthly income which is why Equiton’s Apartment Fund recently celebrated 80 months of consistently positive returns.
Protect and build your wealth. Contact Equiton today to learn more about how our private real estate investment solutions can provide a source of income that can stay ahead of inflation and why private real estate has the reputation of being recession-proof.
1Private Canadian Apartments = MSCI/REALPAC Canada Quarterly Property Fund Index- Residential, MSCI Real Estate Analytics Portal– Accessed July 11, 2022