Why High Consumer Debt Means the (Monetary) System Works
In its recent semi-annual Financial System Review, the Bank of Canada again warned about the perils of the increasing indebtedness of the Canadian household sector. The report also noted that the growth rate of this debt has slowed recently, but it still remains quite high.
While I believe that the BoC is quite right to caution about the possible consequences of a high level of household debt in Canada, I think there’s another important point that these figures convey. The traditional monetary policy transmission mechanism still works quite effectively in Canada. This is a non-trivial point considering the ZIRP (zero interest rate policies) and quantitative easing efforts in other major economies.
Before analyzing that point, let’s take a small step back and take a quick look at how monetary policy—in this case adjusting interest rates—is roughly supposed to work. Using Canada as a rough example, the central bank has a target for inflation (technically core inflation, but that’s an aside). Since 1992 this has taken the form of a band for inflation of between 1% and 3% with the midpoint target of 2% being where the bank is most comfortable with inflation being around.
If inflation edges towards or above the top part of that band, then the Bank will tighten raise (also called “tighten”) interest rates (technically the “overnight rate” but that rate influences interest rates across the economy). A higher interest rate makes it more expensive for people to borrow money, reducing the demand for people to borrow money and cooling (reducing the pressure) on the economy. This is when the bank is “taking the punchbowl away right at the height of the party” as it were, to keep the economy from becoming overheated.
Conversely, if inflation is toward the lower part of its target band, or even below, the Bank will lower (also called “loosen”) interest rates. This is an attempt to make the cost of borrowing less, which will make borrowing money more attractive to people who then will spend (or invest) that borrowed money and boost the economy towards a fuller utilization of resources.
(Aside: There are a lot of inputs that help the BoC determine when rates need to be adjusted, including the global economic situation, how the Canadian economy is compared to the BoC’s forecast of potential output, etc, etc. What I’ve discussed above is just a simple sketch of things).
It is the case at the lower bound of interest rates which is important when considering my initial point, made at the top of this post. When the global economy fell into recession (pulling Canada along with it), the Bank of Canada furiously cut its overnight rate to 0.25%, the lowest level on record. This made borrowing incredibly cheap by historical standards and, reacting rationally and as monetary policy would want, Canadians stampeded to their banks/credit cards/ what-have-you to borrow money . While this had the effect of pushing up consumer debt levels, it provided a nice boost to the economy in the midst of the recession.
With interest rates having increased (slightly) to 1%, the growth rate of consumer debt has slowed according to the Bank of Canada. This shows that monetary policy continues to work well in Canada. However, it is here where the Bank is encountering problems which are why Governor Carney has taken to issuing warnings about consumer debt and the Department of Finance is looking at policy approaches to stymie the debt growth.
Unlike the simple world I outlined above, there are a number of factors that inform the Bank’s decision on interest rates, not the least of which is the strength of Canada’s trading partners and the global economy. With the strength of the global economic recovery (and demand from trading partners) still “unusually uncertain,” it’s hard for the Bank of Canada to tighten interest rates much further without worrying about stifling Canada’s economy. So, “jawboning” and other policy moves might be the only approaches left to the Bank (and Government) to keep consumer debt from ballooning too much.
That’s why the news that Fed Finance is looking to work with the chartered banks to tighten lending requirements is a good move in the short-term. At least until the Bank can increase interest rates from their low (by historical) levels.
