What’s the deal with interest rates? — A Q&A with Jimmy Jean

On June 5, the Bank of Canada cut the overnight policy rate by 25 basis points to 4.75%, the first cut since the onset of the pandemic in March 2020. To get a sense of what it means and where rates are going, we sat down with Vice-President, Strategist and Chief Economist Jimmy Jean and asked him to break it down.

You can also read the full report prepared by Desjardins Economic Studies after the announcement. 

In his press statement, BoC Governor Tiff Macklem justified the cut by pointing to the material progress being made on inflation indicators, which are getting closer to historical inflation numbers. I think there's room for headline inflation to come even lower in the near term than the BoC’s most recent projection.

So, I expect to see interest rates continue to decline over the coming months. How many and how quickly will depend heavily on the data continuing to cooperate. But they should move gradually lower as ongoing mortgage renewals and slower population growth weigh on economic activity, maybe even more than the BoC currently anticipates.

Most borrowers took out variable rate mortgages before rates went up. Those rates are based on a financial institutions’ prime rate, so those borrowers were hit hardest by the soaring interest rates over the last two years. On the plus side, they will start seeing immediate relief from the recent cut.

The cut doesn’t affect borrowers with fixed rate mortgages, who keep their current rate until they renew. Fixed rates are higher than they were a few years ago, but conditions for new borrowers will gradually be looking better. Long-term bond yields are currently lower than shorter-term yields, given the expectation that central banks will get inflation under control. As a result, we’re seeing a significant spread between fixed and variable rates, especially for CMHC-insured mortgages.

We expect the cut to contribute to a rebound in home sales this year, but a few other factors will prevent a more significant recovery. First, it will take time for the lower borrowing costs to take hold in the housing market and the broader economy. Secondly, affordability is still very stretched in a lot of markets. My assumption is that the rebound will begin in earnest only after the worst of the labour market softness is behind us and there's been more rate relief.

The Federal Reserve announced on June 12 that there will be no change to the US interest rate this month. That marks a departure for Canadian interest rates from that of our American trading partners. But our recent research has shown that interest rates tend to be less important to the Canadian dollar than other factors like risk sentiment, oil prices and moves in the broad US dollar index. It takes a very large depreciation in the Canadian dollar to push total inflation noticeably higher. Even then, central bankers tend to see it as a one-time level shift in prices.

Canada should have no qualms cutting rates further while the Fed waits on the sidelines. Officials have to do what’s best for the domestic economy, which has been hit much harder by rate hikes than our southern neighbour. Canadian policy makers have also been joined by the European Central Bank and the Swiss National Bank in June. 

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