Bank of Canada to Announce Bank Rate Rise this Morning: July 20, 2010
In today’s economy, it is not the central bank rate that is crucial to the strength of the economy. Rather, it is the spread between the bank rate and various other interest rates that drives economic activity in positive or negative directions.
The decreasing spread between the bank rate and the rate for sub-prime mortgages was one of the things which perpetuated the financial melt down that led to the 2008-2009 recession.
Credit card interest rates have been more or less stable throughout the 2008 2009 recession. This spread has therefore increased, as the central bank rate approached historically low levels. This has had a twofold economic effect. Credit card issuers, largely banks, have won. Credit card holders, particularly those in society who don’t own other assets such as houses and stocks, have lost. Those most negatively impacted by the recession, individuals and families dependent on immediate income and short term revolving debt to finance their cost of daily living have actual contributed to the increased profitability of the existing credit card business. Despite all the protestations of credit card issuers, the credit card interest rates during the recession smacks of the exploitative usury common in historical times. They hurt the economically weakest in our society at a time when they deserve help. Politicians, who regulate such things and need to provide moral leadership to society, should be ashamed for not addressing this issue.
The decrease in the central bank rate has been tied to decreases in the rate paid on direct savings and other asset type savings accounts at banks. These rates are driven by a number of things. First, they have a relationship to the Bank’s prime lending rates, which are in turn linked to the central bank rate. At the same time, the rate that bank’s pay on savings and other similar asset accounts reflect their desire to get more savings on deposit. In the fact, they compete with other banks and similar institutions for such savings. Bank leaders make management decisions about the spreads between these rates. Essentially, they are in a position to manage their profitability through such spread decisions.
The spread between the central bank rate and savings / asset investment rates have not increased during the recession, even though the raw rates have decreased. That indicates that it is not a shortage of cash, but rather an unwillingness to lend it, that is behind the current problems with small business lending. If this were not so, lenders would be competing to get more cash by increasing this spread.
The decrease in raw rates for savings and other asset based returns has hurt asset owners throughout the recession. As well, asset holders’ have suffered real financial pain through the decrease in the value of assets on the stock markets. However, financial institutions, whose behavior clearly contributed to creation of the recession, have largely been able to shelter themselves through managing the spreads between the central bank rate and the other rates they offer for both savings and lendings. The best witness for this is the return to large profits on the parts of North American banks by the summer of 2010.
A low central bank rate has brought down mortgage rates in Canada. This has lead to a robust housing market place in Canada. In general, housing costs in Canada are at a level which many, including the Economist, believe is unsustainable.
The Canadian banks, and others, are still competing for mortgage business, despite this. Mortgages are structured to pay mostly interest up front, not repay principal. Banks’ profitability from mortgages is therefore tied to turnover in the mortgage market. They tie their mortgage rates to the central bank rate to encourage this turnover. But again, it is their ability to manage the spread, which does not move lock step with the central bank rate, which drives the volatility of the mortgage market, and the value of the housing which reflect this volatility.
Businesses are still hoarding cash according to the Economist. Business investments are driven by risk/return judgments on the part of the involved management leaders. Their investment judgments balance two factors. The first is their evaluation of the future risk related to the investment. Managers see that consumer are still being hurt by the relatively high spreads between the central bank rate and credit card interest rates, and by lower spreads between the central bank rate and savings / asset return rates. Consumers do not have as much disposal income as they had before the recession. As well, the decline in the value of stock market and other similar assets (including housing in the United States) has resulted in a slow down in consumption based on the increase in the value of assets held by consumers. This means that the risk that consumers will not purchase the results of business investments in new products and capacity is still high. At the same time, management leaders are experiencing lower cost of capital rates, which are tied to the central bank rate, as lower. However, business management’s evaluation of the risk related to such investments is still outweighing the contribution of lower capital costs to estimated rates of return on business investments. As a result, they are holding back on investment. The Economist has called this “hoarding cash”.
It is not enough to exhort business to stop hoarding cash. Not even the reputation of the Economist will be sufficient to get business managers to do that. Instead, consumer purchasing power must increase. It cannot increase until at least two things happen. The spread between the central bank rate and credit card rates must decrease. The spread between the central bank rate and return on invested assets must increase. The central bank, through monetary policy, does not directly control either. Bank senior’s managers due. Although they take the changes in the central bank rate into account, they can manage these spreads to suit their short term profitability desires first, and the needs of consumers (and the economy) second.
We no longer live in a world where Keynesian policy, or central bank monetary policy, works directly, in the short term. The growing confusion about the relationship between the central bank rate and the health of the economy reflects the growing complexity of our economic world. We live in a world of spreads of all kinds. Spreads are largely managed by bankers and other financial managers, not politicians. It is time for public commentators on our economy to stop misleading their audience through simple minded comment on changes in the central bank rate. Instead, they need to analyze the differential impact that such changes have on rate spreads. They need to inform us that the spread managers are responsible for what happens in our economy as our politicians and central bankers. They need to place these things in short and long term historical perspective. This is not easy to do in media spots that last a few minutes or take a few paragraphs. But that is no excuse of acting as if public media commentary on these complex dynamics is in fact insightful: something more than 1 person’s open or simple economics based gossip.
Public media business and economic commentators also need to take into account all of the things that impact that intangible called consumer confidence. Increasing taxes either openly or through the indirect taxes called fees negatively impacts consumer confidence. The value added tax increases in British Columbia and Ontario in Canada (HST implementation) are an example of the first. The “eco-fees” that came into effect on 1July in Ontario are an example of the second. Calling something a fee does not mean that it is not a tax. A tax is simply an amount of money taken from individual consumers and commercial organizations by a government, based on its power to legislate.
Day to day consumers can feel the impact of the relationship between rate spreads and direct / indirect taxes on their day to day economic confidence. They don’t need degrees in economics to intuitively feel the impact of such moves by commercial and retail bankers, central bankers and politicians. The least they, as a public audience, deserve from public media commentators on financial dynamics is less “media gossip and personal opinion labeled as insightful analysis” and more true analysis. Public media commentators need to stop their “in-the-movement, in isolation” comments. They need to look at, understand and talk about the connections of things like rate spread changes and tax increases. They need to remember that they have an obligation to educate all of us on the inter-related issues impacting our personal and joint economic health.
A side note.
American, and a number of other, democracies were founded on the principle of no taxation without representation. Generally that has been taken to mean that elected representatives must vote on taxes. When a government moves decisions about taxes from elected representatives to civil servants or to employees of government agencies, it is undermining this basic democratic principle. The tendency of elected governments to do this more and more in the past decades is a shameful thing. Calling the amounts levied on private citizens and enterprises by governmental groups “fees” is a verbal shell game. It does not hide the fact that those who govern, whether elected or otherwise, have a tendency to treat those they govern as “revenue cows”. Historically, every form of government has eventually taxed its citizens into open or passive revolt. Democracy seems to be suffering more and more from this historical tendency. Elected politicians who allow bureaucrats and government agencies employees to impose “fees” on citizens and organizations need to experience a large dose of shame over their non-democratic tendencies.
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