The Dangers of an Extended Period of Low Interest Rates: Why the Bank of Canada Should Start Raising Them Now

Abstract

Interest rates in Canada and in many other countries have not been so low since the Great Depression. 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. These historically low rates were initially a response to the global financial crisis that broke out in 2008. The financial crisis led to a sharp fall in economic activity, a dislocation of the financial system, and the need in many countries to recapitalize banks with public money. 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 current downturn of output compared with its potential, although significant, has been less severe in Canada, and gross domestic product (GDP) has returned to a value closer to the economy’s capacity. In this Commentary, I argue that short-term rates are therefore too low in Canada, a situation that is starting to build in pervasive problems for the economy. 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. Some of the symptoms of inefficient investment and asset price bubbles are already evident in Canada, in the housing sector for instance. The cumulative effect of artificially low interest rates also risks fuelling an underlying inflationary process. Therefore, I recommend that the Bank of Canada start now to reverse some of the monetary stimulus and begin raising interest rates.