Interest rate arithmetic

PURCHASINGB2B MAGAZINE: MAY 2011
I was pretty good at arithmetic when I was a kid. And I don’t think I’ve lost my touch. According to what I was taught in the 1960s, 2 + 3 = 5. That’s what I came up with when I did that addition in my head. Then I found a calculator to verify it and you know what? I was right the first time!
Now, I’m guessing that the people at the Bank of Canada are equally adept with ciphering. Except there seems to be a disconnect…somewhere. Because right now, Canada’s Bank Rate hovers around one percent, when according to the arithmetic of basic economic theory, it should be around five percent.
Clearly, something isn’t adding up and I want to get to the bottom of it. Basic financial theory tells us that the risk-free rate—which is what we’re talking about when we’re discussing the bank rate—should be equal to a combination of anticipated inflation plus real economic growth. According to information released by the Bank of Canada—it’s on their website right now—inflation should be about two percent by the middle of next year.
Meanwhile, the economy is projected to expand this year by 2.9 percent… let’s round up to three. Therefore, the risk-free rate should be equal to two percent inflation and three percent economic growth…or five percent.
Yet the Bank of Canada is holding interest rates at their current, historically low level of one percent. The rationale is straightforward enough: It’s about the Canadian dollar. It’s been surging in the past 18 months against the US greenback. Everything else being equal, when a Central Bank raises interest rates, it leads to appreciation of the currency, which makes sense when you think about it. International investors like higher interest rates and in order to enjoy those higher interest rates, they would have to enter the market and buy Canadian dollars, putting even more upward price pressure on the loonie. The Bank of Canada doesn’t want that to happen.
What’s going on? This is my theory. The economy really isn’t growing, not in the sense of meaning that we’re further ahead than we were a year ago. When I think of “core” expenditures for most North American families–food and fuel are two–we know that they’re eating into more of weekly budgets. Gasoline sales—as measured by volume—are falling in the US even while expenditures on gas are going up. We’re spending more and getting less for it!
If I would have to make an estimate, it would be that we might actually see a slight decline—say one percent— in our standard of living over the next year. And you know what: Two percent inflation plus negative one percent economic growth gets us to a one percent bank rate…and all of a sudden, basic interest rate arithmetic makes sense! b2b