Glenn Stewardson CFP®, FMA
By Richard J. Wylie, MA, CFA
Vice-President, Investment Strategy, Assante Wealth Management
On December 6, 2019, the Bank of Canada announced that its ninth Governor, Stephen Poloz, would be stepping down in June 2020 at the conclusion of his seven-year term. During his tenure, the bank has been successful in keeping core inflation near the 2% mid-point of its target range. Over the same time frame, the bank has also kept interest rates relatively stable and near historic lows. Like virtually all of the world’s other major central banks, it has clearly been attempting to balance the need to stimulate the economy while simultaneously trying to keep inflation down. It is unclear if Poloz’s successor will exercise the same degree of political independence or be as vocal about the state of Canadians’ household debt. Regardless, concerns over household debt are well founded, as it recently hit a new record level. Seasoned investors may be quite comfortable with the use of debt as an investing tool. By the same token, one of the key advantages of professional advice is that a frank discussion of the benefits and risks of the use of debt can take place. Usually, this also means that these same investors have a far better awareness and understanding of their own balance sheets.
While it seems commonplace today, Canada first adopted an explicit inflation-targeting framework in 1991 under then Governor John Crow. Canada was just the second country (New Zealand was the first) to adopt such a framework. The current target (the mid-point of a 1% to 3% range) has been in place since 1995. Successive governors Gordon Thiessen, David Dodge and Mark Carney have all worked within this framework with enviable success. As can be seen in the above chart, inflation1 stood just below 6.0% (Y/Y) at the beginning of 1991. Despite material concerns at the time that the introduction of the GST would fuel a wage-driven inflationary spiral, consumer prices largely moved within the declining target band. More recently, the newest inflation target, core inflation tracker, or CPI-Common, has remained in a very narrow 1.3% to 2.0% range since 2016.
Like all of the world’s other major central banks, the Bank of Canada responded to the 2008-2009 financial crisis by lowering intertest rates and providing an unprecedented level of market liquidity through quantitative easing. As can be seen in the above graph, extraordinarily low interest rates (the official Bank Rate was 0.5%) prevailed between April 21, 2009 and May 31, 2010. Yet, with less-than-robust economic growth now prevailing in Canada and other regions, the question of what more can and should be done arises.
Even though the notion of modern monetary theory (MMT) has not gained much traction in Canada, it has become an election topic in the U.S., where its proponents suggest that considerably greater economic growth2 is possible without concern over rising inflation. Simply put, MMT rejects the notion that government spending is funded by taxes and debt issuance. Rather, the government has the ability to simply print money, by way of the central bank’s printing presses, to fuel consumption. This could be done with impunity up to the point where inflation accelerates. Inflation would only appear when the real resources (labour, capital and natural resources) of the economy are all fully employed. The country that controls its currency can print as much as it wishes and the government will control inflationary pressures through spending restraint when needed. Critics of this theory would be correct to cite well-known historic examples of hyperinflation from the Wiemar Republic (1923)3, Brazil (1985) or more recently, Venezuela (2016), where printing money was unconstrained and fiscal restraint failed to emerge. The rampant money creation that accompanied the U.S. deficits used to fund the Vietnam War provides an example of high inflation that is closer to home.
As can be seen in the above chart, bouts of inflation experienced in the 1970s eventually required extreme measures from the U.S. Federal Reserve as Chairman Paul Volker raised Fed Funds target4 rate to 20.0% in March 1980, a record high. Governor Poloz believes the risks of MMT to be important enough to have mentioned them specifically in one of his first speeches following the announcement that he would be stepping down, and away from any potential political pressure he might feel to implement these ideas. The purpose of his discussion of MMT was to raise questions of its fundamental concepts and warn his audience, and possibly his successor, of the risks of treating this as a viable policy tool.
Governor Poloz also continued to express concerns over the scale of Canadians’ household debt. A reasonable question would be “is this not a problem of the bank’s own creation?” The prime tenet of monetary policy is that lower borrowing costs due to low interest rates encourages borrowing, which translates into increased spending and more rapid growth of the broader economy. Certainly, low interest rates have fostered significant personal borrowing in Canada as Statistics Canada’s latest report5 showed that total household debt had increased 4.0% on an annual basis to $2.3 trillion in the third quarter of 2019. This is a new record, but perhaps more surprisingly the level of Canadian household debt has not recorded a single quarterly decline in the past 29 years, even during the 2008 – 2009 financial crisis.
Perhaps more important than the actual level of household debt is how this debt is supported. Household debt as a percentage of disposable income has been highlighted for comment by the Bank of Canada far more than the outright “stock” or level of debt. Unfortunately, this measure has also seen a consistent increase since 1990. As can be seen in the accompanying chart, in the third quarter of 2019 it stood at 175.9% (indicating that total household debt was about 1.8 times household income). This represents a modest decline since it hit a record of 178.5% in the first quarter of 2017.
As can be seen above the majority (65.2%) of household debt is mortgage debt, which is typically viewed as being more secure than other debt vehicles such as non-mortgage loans and credit card debt. Furthermore, growth in household assets appears to be in step with this increase in debt. As can be seen below, debt was equivalent to only 16.8% of household assets in the third quarter of 2019. This is actually lower (marginally) than its 10-year average of 17.4%. So, it could be reasonably argued that Canadians have not been reckless in their use of debt over the past decade. The concern here would be the possibility of these assets declining in value. Certainly since 2009, Canadians have become accustomed to their financial assets generally rising in value. The same could also be said of the values of properties and homes in many Canadian markets. Still, markets that have continued in one direction for an extended period run the risk of correcting, smoothly or otherwise.
Statistics Canada defines its Household Debt Service Ratio (DSR) as the proportion of household disposable income that is devoted to making required interest and principal payments with respect to total liabilities. As can be seen in the above chart, Canadians were using a 15.0% of their disposable incomes to service their debts in the third quarter of 2019. This is also a new record high. Additionally, since the third quarter of 2017 when it stood at 6.4%, the percentage of disposable income that goes to meet interest costs alone has increased to 7.5%.
Despite the slower economic growth in Canada during 2019, when compared to the U.S., the Bank of Canada held interest rates steady. This was done even as the U.S. Federal Reserve cut interest rates three times (by 0.25% each time) over the course of the year. Interestingly, the Bank of Canada has been clear in its discussions of longer-term domestic economic growth. It appears that growth above 2.0% is above potential. Growth at that rate would eventually close the output gap. Once that took place, 2.0% growth would begin to produce a risk of rising inflation that would require the bank to raise interest rates to slow the economy. As has been the case over most of the current business cycle, one of the bank’s key talking points has been the steady accumulation of household debt. However, regardless of the identity of the incoming Bank of Canada Governor and their own focus on policy points, individuals would be wise to review their own debt positions and understand the effects of any potential change in monetary policy.
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1 The Bank of Canada’s current (primary) inflation target is ‘CPI-Common’ which is most closely associated with Canada’s output gap (the difference between the actual output of the economy and its potential). Initially, the Bank used CPI excluding food, energy and indirect taxes. It then switched (in 2006) to CPI, all-items excluding eight of the most volatile components as defined by the Bank of Canada and excluding the effect of changes in indirect taxes.
2 U.S. GDP growth was 2.1% (annualized) in Q4/2019 and 2.3% for the year 2019.
3 In the Wiemar Republic during 1923, prices doubled every two days.
4 While the Federal Reserve Board sets a target interest rate for Fed Funds, the effective rate varies according to market influences.
5 National balance sheet and financial flow accounts – third quarter 2019. Statistics Canada. December 13, 2019.