Remarks by Paul Beaudry
Deputy Governor
Bank of Canada
June 8, 2023
Victoria, British Columbia
Economic progress report: Are we entering
a new era of higher interest rates?
"Presume not that I am the thing I was..." -
William Shakespeare
Introduction
Thank you for the kind welcome and thank you to the Greater Victoria Chamber of
Commerce for giving me the opportunity to be here today. It is always a real pleasure to
visit beautiful Victoria.
I live in Vancouver, but I often make the trip across to Vancouver Island to take
advantage of the natural beauty here. I love riding the Galloping Goose trail out to
Sooke to visit the potholes or hiking the beaches in Juan de Fuca Park. I could go on all
I hope you won't be
day about the wonders of Victoria and the island, but instead-and
disappointed-I will focus my talk on interest rates.
the Bank of Canada's
First, I want to talk about decision yesterday to raise our policy
rate to 43⁄4%. I will elaborate a bit on our discussion and the thinking behind our
decision.
Then I will take a step back and look at where interest rates may be going two or three
years into the future and beyond. I will consider the question of where interest rates are
likely to settle once inflation has normalized, and whether we may be entering a new
To do this, I'll explore some of the factors that
environment of higher interest rates.
influenced interest rates in the decades before the COVID-19 pandemic and then
discuss why these forces may now be shifting.
The long-term path of interest rates is an important consideration for many household
and business decisions. When a company plans a major investment in a new factory or
a family buys a new house or car, they need to consider the cost of financing over many
- 2 -
years. This includes being ready for the possibility that interest rates could stay higher
for longer.
won't
Now, I claim to know with certainty where interest rates are going, but I can point
to where some of the risks lie. By doing this, I am hoping to help Canadians prepare in
case it turns out we have indeed entered a new, higher interest rate environment.
But as I said, let's start with
the present, as I am sure you are curious to understand our
thinking.
Yesterday, Governing Council raised the policy rate to 43⁄4%. This was our first rate
increase since January.
When we paused five months ago, we said we needed time to assess whether our
forceful monetary policy tightening-425 basis points in less than a year-was
restrictive enough to return inflation to the 2% target. Put another way, we were looking
for an accumulation of evidence that supply and demand were rebalancing, and price
pressures were easing, in line with our inflation target.
By our meeting in April, we were beginning to see some signs that more tightening
might be needed and so we discussed the possibility of increasing the policy rate. At
that time, we were concerned about elevated core inflation and the tightness in the
labour market-including strong wage growth. We also discussed the possibility that
consumer demand could be more robust than expected.
The data since April have tipped the balance. The accumulation of evidence-across a
range of economic indicators-suggests that excess demand in the Canadian economy
is more persistent than we thought, and this increases the risk that the decline in
That's why we decided to
inflation could stall. raise the policy rate.
Let's start with economic growth, which
rebounded in the first quarter of 2023 to 3.1%.
Consumption growth, in particular, was very strong at 5.8%, with household spending
on both goods and services sharply higher. This surprised us. We had expected growth
in demand for services to start to ease off, but Canadians continue to catch up on travel,
entertainment and restaurant spending. More unexpected was the strength of the
rebound in goods spending, particularly the demand for interest-rate-sensitive goods,
like furniture and appliances. We also considered evidence that buyers were returning
to the housing market, even as supply remained tight, which could further fuel
inflationary pressures.
We discussed how much the strength in consumption could be explained by strong
immigration, ongoing pent-up demand and the continued unwinding of supply chain
issues. We determined that while these factors are at play to varying degrees, the
bottom line is there appears to be more momentum in demand than we expected.
We also talked about the labour market. While there are fewer job vacancies,
unemployment remains near a record low. More workers are coming into Canada, but
they are being hired very quickly, reflecting strong labour demand.
unexpected tick up to 4.4% from 4.3% in March. While
On inflation, we discussed April's
that might not seem like much, it was in the opposite direction of what we expected, and
the details behind the headline number were concerning. In particular, three-month
- 3 -
measures of core inflation remain elevated and seem to have lost their downward
momentum. And goods inflation surprised us by accelerating in April, reversing course
after months of deceleration. We still expect headline inflation to have eased in May and
to be near 3% later this summer, but this is largely due to lower energy prices and what
we call base-year effects-the comparison of current price gains with the very large
gains a year ago.
To sum up, when we looked at the recent dynamics in core inflation combined with
ongoing excess demand, we agreed the likelihood that total inflation could get stuck well
above the 2% target had increased. Based on this accumulated evidence, we decided
to raise the policy rate to slow demand and restore price stability.
We'll have more to
say about all of this in our July forecast.
We know this tightening cycle has not been easy for many Canadians. But the
alternative-not controlling inflation-would be far worse, particularly for people living
on low or fixed incomes. When inflation is stable around the 2% target, it removes the
anxiety created by large swings in the cost of living. Price stability means households
and businesses can plan, budget and invest with confidence and allows our economy to
work better. That is why the Bank remains focused on taking the steps needed to
restore inflation to 2%.
Breaking down interest rate movements
yesterday's
That wraps up my discussion of decision, which was very much a look at
what we are considering in the near term. Now let's consider the forces influencing
interest rates in the long term.
To start, let's
look at the 25 years leading up to the pandemic, a period with a clear
downward trend in long-term interest rates in Canada (Chart 1). This downward path is
whether we're talking about mortgage rates, business loan rates
unmistakable, or yields
on government bonds.
- 4 -
Chart 1: Long-term nominal interest rates fell steadily in Canada over the 25 years
before pandemic
Quarterly data, 1995Q1 to 2019Q4 %
12
9
6
3
0
1995 1999 2003 2007 2011 2015 2019
Conventional mortgage rate Business loan rate 10-year bond yield
Sources: Canada Mortgage and Housing Corporation via Haver Analytics and Bank of Canada
Last observation: 2019Q4
To better understand the forces that drove that trend, it will be helpful to distinguish
between three different types of interest rates: nominal rates, real rates and the neutral
rate.
Let me begin with the first two. The interest rates posted by your mortgage broker or set
by the Bank are in nominal terms. To get the real interest rate, simply subtract inflation
from the nominal rate. For example, if the nominal interest rate is 5% and inflation is
stable at 2%, then the real interest rate is 3%.
Why is this important? Because real rates are what determine the value in saving and
the cost of borrowing.
let's
Think about it this way: say you have $2,000 to spend on a trip to the Okanagan
and want to decide whether to go now or save up for a few more years. If the nominal
interest rate is 5% and the rate of inflation is 2%, then in three years your $2,000 trip will
cost you about $2,120, but your savings will have grown to a bit over $2,300. This puts
you ahead by roughly $180, reflecting a 3% real interest rate. You could use that extra
money for a longer stay or a nicer hotel. In that sense, the real rate reflects how much
more purchasing power you'll ultimately get from your savings. If instead you were
borrowing at a 3% real rate, then the real rate would reflect how much purchasing
power
you'd have to give up to service your debt.
When we look at the yield on a 10-year Canadian bond in real terms in Chart 2, we can
see that much of the decline in nominal rates in Chart 1 reflects falling real rates. This
should not be surprising because inflation was quite stable around the 2% inflation target
- 5 -
in the 25 years leading up to the pandemic. We can also see that the decline in long-term
rates was not unique to Canada. Most advanced economies saw similar decreases.
Chart 2: The decline in real yields was an international phenomenon
Semi-annual data, April 1995 to October 2019
%
10
8
6
4
2
0
-2
-4
1994 1998 2002 2006 2010 2014 2018
Canada United States France Germany United Kingdom Canada
Note: For each country, the real yield is computed as the difference between the nominal yield on 10-year government
bonds and a measure of professional forecasters' inflation expectations over the next 10 years.
Sources: National Sources, Consensus Economics and Bank of Canada calculations Last observation: October 2019
let's
To make sense of this downward trend in long-term real rates, turn to the concept
of the neutral rate. As a first step, it is worth noting that long-term real rates largely
reflect where markets expect short-term real rates to be in 5 or 10 years. This time
frame is important because most economists agree that real rates at this horizon are
outside the control of monetary policy and instead determined by deeper, structural
forces. These structural forces shape what economists call the real neutral rate,
meaning the level at which short-term real rates should settle over time.1
Let's
think of this neutral rate as an anchor. Right now, the water is choppy because we
are still feeling the shocks of the pandemic and the war in Ukraine. But that anchor is
where the Bank thinks real rates should settle once the effects of those shocks have
faded, inflation is back at the 2% target and the economy is in balance.
To be clear, the neutral rate is not easy to pin down, nor is it static. It is carried along by
the structural forces I just mentioned, and over time those forces pull all interest rates in
the Bank's
the economy with it-from policy rate to mortgage and loan rates. As a
result, if we want to make sense of the downward trends I just highlighted, it's important
to understand how the real neutral rate is determined and what sort of structural forces
could have caused it to drift lower over the 25 years before the pandemic.
- 6 -
The real neutral rate: Key drivers and their evolution
let's talk about
Now, the drivers of the real neutral rate. In essence, it comes down to
the balance between saving and investment in the medium to long run. Here, the main
idea is that household saving filters through the financial system to finance investments
made by firms. The saving and investment must balance out.
When households have a strong desire to save but firms have few investment
opportunities, the neutral rate needs to fall to balance them out. By contrast, when
businesses have many opportunities for profitable investment, but households have little
desire to save, the neutral rate is pushed up.
Because Canada is a small open economy, it is the global balance of saving and
investment that matters most for our real neutral rate. Most advanced economies are in
the same boat, which is why Chart 2 shows such similar trends across countries.
If we want to understand these trends, we need to consider the structural forces that
could have led to upward pressure on global saving or downward pressure on global
investment. illustrates these forces in action, showing how more desire to save
Figure 1
from households should lead to a lower neutral rate (middle panel) and how the neutral
if firms'
rate would fall even further investment opportunities were simultaneously
shrinking (bottom panel).
I won't be able to touch
While on all the potential forces in my remarks today,2 I want to
flag four that are widely viewed as being key drivers in recent decades-three on the
saving side, and one on the investment side.
- 7 -
Figure 1: Saving and investment determinants of the real neutral rate
S(r)
(r)
rate
Initial equilibrium
neutral
Real
I(r)
Saving (S), Investment (I)
S(r)
(r)
rate
neutral
New equilibrium with
upward pressure on saving
Real
I(r)
Saving (S), Investment (I)
S(r)
(r)
rate
neutral
Real
New equilibrium with upward pressure on
saving and downward pressure on investment
I(r)
Saving (S), Investment (I)
- 8 -
Demographics and aging
The first force has to do with demographics. Over the past two decades, both here in
Canada and in other countries, the baby boomers have been nearing the end of their
working years. This is important because people tend to save more as they approach
retirement. Think of it this way: a 20-year-old is not likely to save as much as someone
in their forties or fifties, because the older person is more focused on saving for
retirement and, being further into their career, is also likely saving out of a higher salary.
Large shares of the populations of advanced economies were at this saving-intensive
stage of life, and this was a source of both upward pressure on global saving and
downward pressure on real interest rates. These impacts were reinforced by an
increase in life expectancy, which meant that people had to save more than previous
generations to be ready for a longer retirement.3
Integration of China and other high-saving economies into the global economy
The second force has to do with the rapid rise of China and other low- and
middleincome economies. Saving rates in many of these countries were high in recent
decades. In part, this reflects lessons learned from financial crises, but it is also
because these countries have weaker financial systems and social safety nets. If you
can't get insurance or a loan, if you don't have a
or reliable pension, then you must put
aside more money to cover those gaps. And demographic trends similar to those I
described under the first force would also have supported saving in some of these
countries. As a result, as these nations grew and integrated into the global economy,
they brought with them a new, large pool of saving that added to downward pressures
on real rates.4
Rising inequality
The third force is rising income and wealth inequality. This trend has been much less
pronounced in Canada than in other jurisdictions, such as the United States, but it
matters in the context of global saving. Rising inequality means more resources are
3
For details on these demographic mechanisms, see G. B. Eggertsson, N. R. Mehrotra and J. A. Robbins,
American Economic Journal:
"A Model of Secular Stagnation: Theory and Quantitative Evaluation,"
Macroeconomics 11, no. 1 (2019):1-48; and E. Gagnon, B. K. Johannsen and D. López-Salido,
IMF Economic Review
"Understanding the New Normal: The Role of Demographics," 69, no. 2 (2021):
357-390.
4
Bernanke,
Among others, see B. S. "The Global Saving Glut and the U.S. Current Account Deficit"
(remarks at the Sandridge Lecture, Virginia Association of Economists, Richmond, Virginia, March 10,
Gourinchas, of and
2005); R. J. Caballero, E. Farhi and P.-O. "An Equilibrium Model 'Global Imbalances'
Low Interest Rates," American Economic Review 98, no. 1 (2008): 358-393; and N. Coeurdacier,
Jin, American Economic Review
S. Guibaud and K. "Credit Constraints and Growth in a Global Economy,"
105, no. 9 (2015): 2838-2881.
- 9 -
concentrated among richer households, who tend to save more than average savers do.
This created a growing source of downward pressure on real rates.5
The "missing investment" puzzle
The fourth force is on the investment side. A surprising trend in the years leading up to
the pandemic was that levels of investment in advanced economies generally remained
low despite a large fall in real interest rates. If the only forces at play were on the saving
side, then lower real rates should have triggered higher investment (Figure 1, middle
panel). This means another force was likely holding back investment over this period,
putting further downward pressure on real interest rates.
The precise reasons for this "missing investment" are difficult to
pinpoint,6 but I can
offer three examples of factors that may have played a role. The first is that profitable
investment opportunities may have dwindled over time as more and more low-hanging
fruit was picked. Second is that competitiveness has decreased: large and established
firms have grown to dominate many industries, making it difficult for new and more
innovative entrants to gain traction. And a third factor is that investment has shifted from
physical assets, such as airplane engines and appliances, to digital or otherwise
intangible ones, which may be more difficult to finance or to use as collateral.7
Where are real rates headed from here?
Together, the four forces I described contributed to a sizable fall in real rates over the
25 years leading up to the pandemic. The big question now is: where do interest rates
go post-pandemic?
There's a
lot of uncertainty surrounding that question-and a significant diversity of
As a starting point, it's important to
views among economists. understand that most of
the structural forces driving the neutral rate are slow-moving, so you would not normally
expect to see major changes over the span of just a few years.
Consistent with this, the International Monetary Fund has said it sees no evidence of
changes to the neutral rates of advanced economies compared with pre-pandemic
5
Peruffo,
See J. Platzer and M. "Secular Drivers of the Natural Rate of Interest in the United States: A
Quantitative Evaluation," International Monetary Fund Working Paper No. 2022/030 (February 11, 2022);
and L. Straub, "Consumption, Savings, and the Distribution of Permanent Income," Harvard University
Department of Economics working paper (June 5, 2019).
6
The term "missing investment puzzle" was
originally coined by Bank of England Governor Andrew Bailey
Bailey,
in a recent speech. See A. "The economic landscape: structural change, global R* and the
(speech delivered
missinginvestment puzzle" to the Official Monetary and Financial Institutions Forum, July 12,
2022).
7
Gordon,
For details on these three factors, see R. J. "Is U.S. Economic Growth Over? Faltering Innovation
Confronts the Six Headwinds," National Bureau of Economic Research Working Paper No. 18315 (August
and T. Philippon, Brookings
2012); G. Gutiérrez "Investmentless Growth: An Empirical Investigation,"
Papers on Economic Activity 48, no. 2 (2017): 89-169; and Bailey (2022).
estimates.8 And when we look at our own models, our most recent analysis suggests
Canada's
neutral rate has not drifted much from its pre-pandemic range and currently
lies around 0%-1% in real terms, or 2%-3% in nominal terms.9
Those ranges are our base case for where we think short-term rates will settle once
inflation returns to normal. However, the risks around that base case are tilted to the
upside. Looking across the four forces I just listed, there are good reasons to believe
that some may be reaching a plateau or even changing course. That makes it unlikely
the real neutral rate will fall below pre-pandemic estimates and creates a meaningful
risk that it could go up.10
Take demographics and aging. In many countries, large shares of the population are no
longer saving in preparation for retirement but are actually retired-so they are in a
stage of life when people typically start spending their savings. This should be a source
of downward pressure on global saving and upward pressure on real rates, though the
precise extent and timing are difficult to predict.
To be clear, this is not only a story about baby boomers in advanced economies. The
one-child policy in China has led to a similar demographic shift in that country, shrinking
the pool of saving it contributes to the global economy.11 And, barring significant
low- or middle-income
structural or political changes, it seems unlikely that another
country will be ready to bring in a new, China-sized pool of saving over the coming
years. Geopolitical pressures could also make some countries less willing or able to
channel their saving into the global financial system, relative to the patterns we saw
over the 25 years before the pandemic.
inequality
Some of the underlying drivers of could also be waning and therefore causing
less drag on real rates. For example, globalization may be stalling relative to the pace
we saw in the 2000s,12 and the geopolitical pressures I just touched on could even send
it into reverse. That could lead to less inequality within advanced economies, where the
8
See International Monetary Fund, "Chapter 2:The Natural Rate of Interest: Drivers and Implications for
Monetary Policy,"
World Economic Outlook: A Rocky Road (April 2023).
9
Bank's most recent assessment of the Canadian neutral rate
For details on the and a newly enhanced
model supporting it, see, respectively, J. Champagne, C. Hajzler, D. Matveev, H. Melinchuk, A.
PoulinMoore, G. K. Ozhan, Y. Park and T. Taskin, "Potential output and the neutral rate in Canada: 2023
assessment," Bank of Canada Staff Analytical Note No. 2023-6 (May 2023); and Kuncl, M., and D. Matveev,
2023, "The Canadian Neutral Rate of Interest through the Lens of an Overlapping-Generations Model,"
For the Bank's
Bank of Canada Staff Discussion Paper No. 2023-5 (February 2023). last pre-pandemic
assessment, see T. J. Carter, X. S. Chen and J. Dorich, "The Neutral Rate in Canada: 2019 Update," Bank
of Canada Staff Analytical Note No. 2019-11 (April 2019).
10
For a detailed exploration of many of these issues, see C. Goodhart and M. Pradhan, The Great
Demographic Reversal: Ageing Societies, Waning Inequality, and an Inflation Revival
(Cham, Switzerland:
Palgrave Macmillan, 2020).
11
"China's High Savings: Drivers,
See L. Zhang, R. Brooks, D. Ding, H. Ding, H. He, J. Lu and R. Mano,
Prospects, and Policies," International Monetary Fund Working Paper No. 2018/277 (December 2018).
12
"Charting Globalization's Turn to Slowbalization After Global Financial
See S. Aiyar and A. Ilyina, Crisis,"
IMF Blog (February 8, 2023).
benefits of globalization have generally not been shared evenly.13 Population aging
could further decrease inequality-as more and more people retire, labour becomes
scarce relative to capital.
the "missing investment"
Finally, with respect to puzzle, the transition to a low-carbon
economy is creating substantial new investment opportunities in green technology and
green infrastructure. Adding to this, rapid advances in artificial intelligence could also
reverse some of the investment-side weakness that I mentioned earlier. For these
reasons, we may be entering a new era of public and private investment, and this could
put upward pressure on real rates.
Conclusion
As you can see, important structural forces will affect rates in our post-pandemic world
and beyond. My overall argument today is that a base-case scenario where the real
neutral rate remains broadly in its pre-pandemic range is possible, but the risks appear
the Bank's
mostly tilted to the upside. In view, that makes it more likely that long-term
real interest rates will remain elevated relative to their pre-pandemic levels than the
opposite.
Simply put, it's important to think ahead.
So what does this mean for you? I hope that by
highlighting some key drivers of long-term real interest rates and how they may evolve, I
will help people be better prepared in the eventuality that we have entered a new era of
structurally higher interest rates. You need only look to the recent stresses in the global
banking sector to see examples of poor planning for the possibility of higher rates.
And while I explained why considerable uncertainty remains around the outlook for real
rates, let me close by circling back to nominal rates, which you will recall include an
inflation component. Let me be clear: there should be very little uncertainty about that
inflation component in the medium to long run. The Bank is committed to restoring price
stability for Canadians by returning inflation to the 2% target.
As I said earlier, we know higher interest rates are not easy for Canadians. But we also
know that persistently high inflation would be harder. Our decision yesterday to raise the
policy rate was not taken lightly. It was something we felt was necessary, based on the
accumulation of evidence that I outlined for you today. We are committed to restoring
price stability for the benefit of all Canadians.
Thank you for your time. I am ready for your questions.