Bank of Canada interest rate expected to rise 0.75% to slow inflation

The Bank of Canada’s biggest interest rate hike of 2022 is set to take place this week and could be the biggest so far this year.

Analysts expect the bank to raise the rate by 0.75%, taking it from 1.5% to 2.25% – marking the fourth consecutive increase this year, after a low rate of 0.25% for two years during a pandemic.

The rate hasn’t topped 1.75% since 2016, which will put Canada’s mortgage stress test in “uncharted territory”, according to Michael Carney, director of business development at real estate listings platform HouseSigma.

Borrowers will need to show they can afford to pay their mortgage at a higher rate, qualifying for 5.25% or 2% more than the bank is offering, whichever is higher. Such an escalation will not only be difficult for new borrowers looking to enter the property market, but also for people whose mortgages need to be renewed.

The last time the rate was 2.25% was in April 2009 in the wake of the 2008 recession, but at the time the reduced mortgage rate was only 3.85% and it didn’t. there was no resistance test.

After the fourth hike expected on July 13, analysts predict that there could be two more hikes before the end of the year. Previous increases were made between March and June.

The bank’s upcoming increases are a measure to combat soaring house prices and dampen runaway inflation that hasn’t been seen in generations.

Canada’s inflation rate hit 7.7% year-over-year for May, making it the biggest rise in consumer prices since 1983. And that’s compounded by increases earlier this year, including 6.8% in April.

The current inflation can be attributed to the supply of goods and services not matching the pandemic demand recovery; the Bank of Canada estimates that the demand for goods and services is becoming greater than what the economy can produce. Other factors include the war in Ukraine which is driving up energy and commodity prices, and China’s zero-COVID strategy which is compounding global supply chain issues.

According to Bob Dugan, chief economist of the Canada Mortgage and Housing Corporation (CMHC), a Bank of Canada interest rate that reaches 2.5% at the beginning of 2023 and remains at this level until the end of 2025 is assumed to be sufficient to control inflation given the sensitivity of households to rising rates due to their high indebtedness. In this scenario of moderate interest rates of 2.5%, it does not stimulate the growth of the economy nor does it contract it.

The high interest rate scenario sends it to 3.5% at the start of 2023, before gradually reducing it to the “neutral” interest rate of 2.5%.

Dugan thinks both scenarios will send inflation to a healthier 2% by the end of 2023.

The moderate interest rate scenario would reduce Canada’s GDP growth to 4.1% in 2022 and 22% in 2023, while the high interest rate scenario would result in much lower economic growth of 3.4 % in 2022 and 0.7% in 2023. The high interest rate scenario would trigger a “mild recession” between late 2022 and early 2023.

The unemployment rate would reach as high as 7% at the start of 2023 in the high interest rate scenario, compared to the historic low of 4.9% in June 2022.

Of course, the resulting rise in unemployment and slower wage growth will make home ownership more difficult, and rising rates will increase construction costs due to higher financing costs, the all in addition to the skyrocketing costs of building materials and labor.

CMHC expects the nation’s housing market to experience a slowdown by the middle of 2023, with the average home price falling 3% to 5% and home sales falling 29% to 34% compared to mid-2022.

“The high rates of house price increases over the past two years have been unsustainable. The cost of housing has reached unaffordable levels for a large portion of new home buyers, translating into a slowdown in 2022. Expected increases in borrowing costs are contributing to a further slowdown in house price growth in 2022 and 2023,” says Dugan.

Mortgage rates won’t stabilize until 2024, when house prices return to positive but moderate growth, supported by rising household incomes and rising immigration.

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