The painful end of free money as real interest rates start to rise

It will likely be hard to convince Canadians struggling with newly increased mortgage payments, but until very recently money has been free.

Until recently, during that latest surge in inflation, borrowing to buy something was actually a lot cheaper than waiting to buy it a year later. That is because what economists call real interest rates were negative.

Even this week as the Bank of Canada increased interest rates by another quarter of a percentage point to 4.75, the bank's benchmark rate remains only slightly higher than the current rise in average prices.

But even that's relatively new. As Bank of Canada deputy governor Paul Beaudry explained on Thursday in a speech to the Victoria Chamber of Commerce, real interest rates have been plunging all over the world since the early 1990s.

According to Beaudry, that could be about to change, not just until inflation is under control but over the long term.

For a lot of people the concept is not easy to understand, but according to Stephen Williamson, one of Canada's top experts in central banking, the gap between real and nominal interest rates has a critical impact on the wellbeing of savers, shoppers and borrowers. And to help explain, he uses apples.

"Say we're just dealing in apples," said Williamson, Stephen A. Jarislowsky Chair in Central Banking at Ontario's Western University. "Say I borrowed an apple this year and I pay you back an apple a year from now, that's a real interest rate of zero."

In other words, although you have to replace it with another apple when the new crop comes in, in real terms the apple cost you nothing for a whole year. Generally that is not the way we think the world works.

But with interest rates so low last fall, borrowing money at about three per cent to buy a piece of furniture, say, or even grocery dry goods inflating at a rate of 10 per cent that you could keep on your shelf for a year, actually made you money.

In apple terms, that's a bit like borrowing an apple now and paying it back minus a bite. 

"That's a good deal," said Williamson in another interview a year ago. "I should be borrowing like crazy."

That's exactly what people did, borrowing money at low rates, helping to bid up the price of houses to astronomical heights, taking Canadian consumer debt to world-beating levels.

At the time Williamson predicted that was something that couldn't last and it hasn't.

As Beaudry explained on Wednesday, for nearly 30 years, the Bank of Canada hasn't had to worry about inflation. The opening of China to the world economy, globalization, large savings rates by boomers and growing inequality that allowed rich people to invest and not spend meant that by 2018 real interest rates had fallen below zero.