Preparing for higher interest rates
By Peter Diekmeyer • Bankrate.com

Canadian borrowers have had it pretty good lately. Mortgage interest rates, already at historic lows at the start of the year, fell even further during January and February. The posted rate at CIBC for a five-year closed mortgage (which tracks that of other major Canadian banks) was just 5.39 per cent this week, down from 6.55 per cent in early January. Smart shoppers and hagglers can do even better.

As if that weren't enough, financial institutions, taking their cue from the Bank of Canada's low overnight rate, have kept interest rates low on a variety of other borrowing products ranging from consumer loans to some credit cards.

However, according to one expert, that may soon change.

"Earlier this year, we had forecast that the central bank would only begin to raise its policy rate in October," says Francis Fong, an economist at TD Bank Financial Group. "However, due to strong economic data and the continued stickiness of core inflation, we now believe that it will act as soon as July."

Low borrowing costs matter
Interest rates are one of the most important influencers of Canadian economic activity. When consumers need to pay more to borrow money, they have less available to buy stuff like cars, televisions and restaurant meals. That, in turn, means the businesses that produce and distribute those things all suffer.

To put things in perspective: A one per cent increase in the interest rate Canadians pay on the approximately $1.3 trillion in household debt they owe would leave them with $13 billion less to spend each year.

Canada's federal and provincial governments -- which, as Avery Shenfeld, chief economist at CIBC World Markets points out, have been running combined deficits of close to 10 per cent of the country's Gross Domestic Product, or GDP, -- are also big beneficiaries of low borrowing costs. For example, in last week's federal budget, Finance Minister Jim Flaherty announced Canada would run a $49 billion deficit during 2010-2011, following a $54 billion gap this year, much of which will have to be borrowed.

The country's current ultra-low interest rates date back to the wake of the economic crisis, when the Bank of Canada quickly brought its policy overnight rate, which influences many of the country's other key rates, down to just 0.25 per cent. The move, which echoed policies of the U.S. Federal Reserve Board and those of many of the world's other major central banks, is widely credited with having kept Canada out of a serious downturn, far worse than the one from which we are emerging.

However, the Bank of Canada's drastic cuts to its policy rate turned out not to be enough. So, last year, the central bank promised to keep its lending rate near zero until the middle of this year. The hope was that consumers, knowing they would not be hit with an abrupt rise in borrowing costs, would then have the certainty they needed to go out and spend.

The inflation problem
The good news is the Bank of Canada's boldness seems to have worked. During the fourth quarter of last year, Canada's real GDP grew at an impressive rate of five per cent. Furthermore, February employment data are expected to show that 20,000 jobs were created that month.

So, if low interest rates are good for consumers, businesses and governments, why doesn't the Bank of Canada always keep them low?

The reason is inflation. If interest rates are too low, for too long, prices inevitably start to rise. If unchecked, inflation can get really bad. One only has to look at the experiences of South American countries such as Argentina and Brazil during the 1980s for examples of how quickly inflation can spiral out of control when central banks run overly loose monetary policies. For a more extreme example, one only has to look at Zimbabwe today, one of the world's poorest countries, which owes a good chunk of its most recent deterioration to an inability to keep inflation under control.

The challenge for central bankers today is that once inflation gets into the system, it is terribly hard to get it out. The last time that happened in Canada was during the early 1980s, and it caused a massive recession. The resulting unemployment levels ended up far higher than what we see even today. As a result, most policy analysts expect that the Bank of Canada will begin to tighten its policy rate long before inflation starts to become a real problem.

The upshot is that Canadian consumers need to start preparing for a higher interest rate environment right now. At a minimum, that would suggest not rashly borrowing to finance immediate consumption. However, the more ambitious would do well by also paying down some of that $1.3 trillion that Canadian households already owe.

Peter Diekmeyer is a writer living in Montreal.