INTEREST RATES: Bank of Canada and Interest Rates: Higher Is Not Always Bad

On Tuesday, the Bank of Canada raised its key lending rate from 0.50 per cent to 0.75 per cent.

Interest rate policy is often divisive, pitting borrowers against savers and investors against speculators.

On balance, this rate increase will be good for Canada.

The country's economy has reached a level that is the envy of others, judging by the accolades received in the international press.

However, using low rates to stimulate our economy towards an even higher trajectory could create imbalances that will eventually risk our new global economic standing.

To some, such as politicians, speculators and profligate consumers, a juiced-up economy sounds like a fantastic proposition.

Unfortunately, most Canadians don't fall into any of these categories. If interest rates are kept too low for too long, economic resources begin to flow rapidly to relatively unproductive uses. In the end, disasters such as real estate bubbles pose the greatest risk.

We only have to look south to see what an era of "easy money" interest rate policies have achieved: a real estate meltdown and an economy that has remained flat for a decade when the effects of financial engineering and over-borrowing are netted out. Apart from some lucky real estate speculators who timed things perfectly, is the U.S. better off?

Higher rates would have played an important role in bringing balance to the U.S. economy.

Instead, there were some stunning side effects of low rates that included the statistic that 40 per cent of all job creation was related in some way to real estate (agents, bankers, mortgage brokers, construction firms, etc.) before the bubble burst.

Higher rates would have helped other service and manufacturing industries to compete for the labour that was otherwise attracted to real estate with its fevered speculation and promises of unending growth.

In a concerning development, real estate prices in Canada are back at record levels.

In many cities prices exceed afford-ability indices.

If the bank rate is kept too low for much longer, Canada risks the potential of becoming an economy that is too dependent on maintaining real estate price trends, inhibiting our ability to grow beyond the currently hot economic industries of construction and resources.

The future of our economy will be on more solid ground with more diversification and job growth in other areas, and interest rate policy will have an effect on this.

Another benefit of higher rates is to provide savers with a yield. Recently, savings rates in Canada have plummeted as Canadians are being induced to borrow and spend while employment remains strong and rates remain low. In addition, there is reduced incentive to save and invest when yields are so low.

Even worse, for those who are saving or who depend on current investment income, there is the temptation to invest in lower quality investments in order to pick up a little more yield.

The asset-backed commercial paper catastrophe illustrated the hazards of this strategy for income-seeking investors who did not have the resources to assess the true underlying quality.

Finally, being able to cut rates in a time of crisis is crucial.

However, this tool is drastically compromised when rates are already severely low, tantamount to "pushing on a string."

If the anemic global economy begins to impact Canada through trade flows, we are going to need all the policy ammunition we can muster.

Increased rates now will ensure that we are able to fight that battle if it arrives, thereby protecting our newly acquired, and envied, economic advantages.

(prepared by Mark Jaysayko & Neil McIver/Vancouver Sun)