May 15, 2013 – After an extended period of record-low interest rates, the Bank of Canada should reverse some monetary stimulus and begin raising interest rates, according to economist Paul Masson. In “The Dangers of an Extended Period of Low Interest Rates: Why the Bank of Canada Should Start Raising Them Now,” published by the C.D. Howe Institute, Masson argues there is urgency for the Bank to act in view of the economic distortions and financial risks low interest rates pose for Canada.
“We are building in pervasive problems for the economy,” notes Masson. “Below-equilibrium interest rates for an extended period distort investment decisions, leading to excessive risk taking and inefficient and ultimately unprofitable investments. They also encourage the formation of asset bubbles whose collapse could lead to a recurrence of the recent financial crisis.”
Interest rates in Canada and in many other countries have not been so low since the Great Depression, notes Masson. When taking into account inflation, short-term interest rates are negative in most developed countries, including Canada where the overnight rate currently stands at 1 percent in nominal terms.
Historically low rates in most developed countries were initially a response to the global financial crisis that broke out in 2008, says Masson. Since then, output growth has resumed in the United States, but unemployment remains unsatisfactorily high. In the European Union, the recovery has been hampered by high public debt and fears of a breakdown of the euro area.
Canada, however, does not face the same problems as either the United States or the EU. Its financial system was exposed to a much lesser extent to complicated sub-prime, mortgage-backed securities, and its economic difficulties are nowhere near as pronounced. The downturn of output was less severe in Canada, and gross domestic product (GDP) has returned to a value closer to the economy’s capacity. These conditions do not justify Canadian interest rates that are so low relative to historical levels, adds Masson.
“Some of the symptoms of inefficient investment and asset price bubbles are already evident in Canada, in the housing sector for instance,” says Masson. “Low interest rates threaten the sustainability of pension funds and other institutions with long-dated liabilities. And Canadians are building up record-high levels of personal debt. While the government has tried to offset these effects with other prudential measures, the latter are not a substitute for removing excessive monetary stimulus. After five years of record-low rates, the time for the Bank to start raising rates is now.”
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For more information contact: Paul Masson, former economist at the IMF, the OECD and the Bank of Canada. Phone: 1-416-865-1904, or email: cdhowe@cdhowe.org