Rising Interest RatesInflation Outlook and Variable Rates

Statistics Canada released July inflation data on Friday. The annualized rate of inflation for the month was 1.3%, up slightly from June’s 1.2% reading. Consensus estimates were in the range of 1.4%. Transportation costs were up significantly, led by gasoline prices which increased more than 6%. The cost of new vehicles in July rose by about 2% from a year ago. Canadians did get some relief at the supermarket as overall food costs increased only 0.8%. This was the smallest increase in more than three years and reflects intense competition and some new entrants to the retail food industry.

The Bank of Canada’s core inflation index rose 1.4% in July. The Bank’s target rate for inflation is 2% and in its most recent Monetary Policy Review, it emphasized that its key overnight benchmark rate would only rise once its core inflation index began to threaten the 2% threshold. This was projected to be in about mid-2015.

For the mortgage industry, the inflation data is important in terms of the trajectory of variable rate products. As fixed rates rise in response to rising bond yields, the spread between fixed and variable widens, making variable rates much more attractive, at least in the short term. So, with the Bank of Canada not expected to move its key rate for at least another year or more, and if bond yields continue to rise, mortgage product choice may tilt further toward variable rate products.

CIBC economist Benjamin Tal commented last week that although prime rate increases are not coming any time soon, when they do come either later next year or in 2015, they could come quickly and sharply. Once inflation needs to be tamed by the Bank of Canada through monetary tightening, small incremental increases to the bank rate of 25 basis points may not be enough to do the job. By the time the Bank’s key overnight rate does rise, Mr. Tal suggested that it will have a lot of catching up to do in relation to other rates.

This is expected to play out in the medium term (the next 12 to 24 months) which means that a new five year term variable rate mortgage today starting at less than 3% will very likely be subject to significant increases by at least the mid-point of the term. The extent of those increases is obviously difficult to predict. That’s why Canadians rely on mortgage professionals to guide them to the choice which is best for them.

If you would like to discuss your mortgage, please contact me.

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