There is considerable debate over where the “neutral” real interest rate is today in practically every country in the aftermath of the pandemic and all the policy responses and economic distortions that followed suit. And nowhere is this debate more acute than in Canada where the consensus on Bay Street and at the Bank of Canada is leaning toward a view that there has been a structural shift higher.
Our analysis runs contrary to the consensus. And this will be a prime reason the Bank of Canada will be forced into rate-cutting mode sooner rather than later. It’s also fodder for our generally downbeat view on the Canadian dollar.
To be clear, the real neutral rate – or R-star – is essentially the inflation-adjusted interest rate that prevails when the economy grows at its potential and there is full employment and stable (on-target) inflation. It is determined by the underlying economic fundamentals (not cyclical forces) and can be thought of as the interest rate that equilibrates demand for investment with savings flows.
Our research concludes that R-star continues to be pulled down by slumping productivity, widening income inequality, and increasing demand for safe assets – factors that outweigh mild offsetting pressure from immigration and public debt. The drivers of the neutral rate have not reversed their course, and current evidence suggests that the future will be one of lower rates in Canada, not sustained higher rates.
Falling behind in the productivity race means lower neutral rates not just in absolute terms, but also relative to the U.S. (current bond pricing seems to reflect this to some degree), and is long-term bearish for the Canadian dollar and bullish for the fixed-income market.
The BoC hiked policy rates by 475 basis points since March 2022 to 5 per cent and pursued the most aggressive tightening cycle since the late 1980s. While it is clear that monetary policy is restrictive, the question of “how restrictive” remains puzzling.
To answer this, first, one has to estimate the neutral interest rate (the difference between the overnight rate and the nominal neutral rate would quantify the restrictiveness). This matters because the lower the neutral rate, the more cuts would be needed for the BoC to move from a “restrictive” to a “neutral” monetary policy.
To gauge the stand of monetary policy, central bankers must know the equilibrium rate of interest. If the overnight rate is above the nominal neutral rate (real neutral rate plus inflation target of 2 per cent), monetary policy would be restrictive, and otherwise, accommodative. The BoC left its measure of the neutral rate unchanged from its 2022 estimate within the range of 2-3 per cent (0-1 per cent in real terms, after inflation) in the latest Monetary Policy Report in October, 2023. Meanwhile, the New York Fed took down its estimate (on an inflation-adjusted basis) from 1.7 per cent in 2022Q3 to 1.3 per cent in 2023Q3, corresponding to 3.3 per cent in nominal terms.
As R-star is an unobservable variable, contemporaneous estimates are notoriously uncertain. Governor Tiff Macklem seems not to be persuaded by the Bank’s models and suggested in November that “there are some reasons to believe it’s more likely that the neutral rate is higher than lower.” Adding to this were the remarks from former deputy governor Paul Beaudry in June: “The risks appear mostly tilted to the upside … that makes it more likely that long-term real interest rates will remain elevated relative to their pre-pandemic levels than the opposite.”
Beaudry justified his stand on higher neutral rates by mentioning i) aging demographics, ii) shrinking global savings mainly due to China, iii) a possible easing in income inequality, and iv) higher demand for investments as a result of a transition to green technology and advances in AI.
We argue that the majority of forces that drive the neutral rate down have not reversed their course and there are more reasons to think that the neutral rate is heading lower than higher. Labour productivity fell in 12 of the past 13 quarters and is 2.5 per cent below the year-ago level. Unlike the U.S., Canadian productivity did not pick up and continues its secular downtrend – in terms of the level, it is back to where it was 10 years ago. While some point to productivity-enhancing developments such as AI as an answer, they are unlikely to move the needle in the near term enough in the face of a massive deleveraging cycle that awaits households and chronically low business investment. Savings will rise as households anticipate mortgage renewals, and firms will have to choose between rolling over their debt and servicing it at a higher cost or retiring it. In either case, future demand for investment faces downward pressure, pushing down the neutral rate.
Another major determinant of the neutral rate, the wealth/income inequality, has increased gradually in Canada from 2020 to 2022 – the Gini index of net personal wealth (a measure of wealth inequality) stood at 0.74, the highest level since 2007. Inequality likely worsened in 2023 with low-income consumers bearing much of the inflation burden. This upward trend in inequality is prone to stay with low and middle-income households suffering elevated food and shelter prices and rising unemployment. Meanwhile, high-income households spend a much smaller proportion of their income on goods and services. They likely are owners of capital, in which case they have benefited from higher shelter costs and an incoming rally in the fixed-income space. A rise in income/wealth inequality will drive down the neutral rate as the rich tend to save more than the average household.
Regarding demographics, the neutral rate in Canada has both upside and downside risks. An immigration-led rise in population (+3.2 per cent year over year in 2023Q4 as per Statistics Canada, the highest yearly increase since 1958) is pushing up labour supply, hence driving up the neutral rate through higher potential GDP growth even though the unemployment rate keeps rising (up +0.9 percentage points to 5.8 per cent from the cycle low). Over two-thirds of new immigrants are between 25 and 64 years old, contributing to the much-needed labour supply in Canada.
As households age, they save more in preparation for longer retirement, but not so much once they are old. With a record number of 65+ year-olds as a share of the total population (22.4 per cent), a possible drawdown of savings from older people will exert further upward pressure on the neutral rate. However, the aging population also creates upward pressure on government spending, which could crowd out private investment and productivity. Overall, it is hard to tell whether a drawdown in aggregate savings is enough to outweigh the lower demand for investment. So, the effect of aging demographics on the neutral rate remains in question.
Lastly, economy-wide debt in Canada is modestly higher than the U.S. (337 per cent versus 335 per cent of GDP) – and excessive debt burdens, which represent a future drag on economic growth, are also a key anchor for a continuing depressed level of the equilibrium natural rate of interest (as has long been the case in Japan where total debt relative to GDP stands at 658 per cent). We see the balance of forces pointing to R-star heading lower and what this means is that the longer the BoC stays on the sidelines and does not adjust policy rates lower, there will end up being an undesirable tightening in monetary conditions – for an economy which is now flatlining in real terms. When the BoC eventually cuts rates, we think it will need to be below the current 2 per cent estimate of neutral.
What does this all mean for the markets? The obvious trade is in the fixed-income space, which will be a primary beneficiary when the BoC cuts policy rates by more than 300 basis points to get to the neutral rate. The other major implication is on the Canadian dollar. Although the U.S. and Canada share many similar characteristics (such as income inequality and population aging), they differ significantly in terms of productivity growth. This is a key factor. Productivity in the U.S. is expanding +2.5 per cent year over year which compares with a -2.5 per cent slump in Canada. This means that neutral rates will diverge from historical patterns, and interest rate differentials in the future will work against the Canadian dollar. In other words, the loonie should find equilibrium at a weaker level than has historically been the case (as in, at any given level of commodity prices).
David Rosenberg is founder of Rosenberg Research, and author of the daily economic report, Breakfast with Dave. Atakan Bakiskan is an economist with the firm.
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