A recent piece in the Financial Post titled “How many times can economists cry wolf about interest rates” caught my interest because I – like many economists in Canada – have been expecting interest rates to eventually start to rise and yet they do not. So when will Canadian interest rates start to go up? My knowledge of money and banking and monetary economics is pretty rudimentary but I'm feeling adventurous in the New Year.
Take a look at Figure 1. I used the monthly estimates of M2 for Canada constructed by Cherie Metcalf, Angela Redish and Ron Shearer for the period 1871 to 1967 and combined them with the monthly estimates of M2 for 1968 to the present from Statistics Canada (v41552796). I took the monthly average each year for the period 1871 to 2013 and used this annual average to estimate the annual growth rate for M2. Over the entire period 1871 to 2013, the average annual growth rate of M2 was 7.2 percent. While growth in 2009 during the financial crisis was 13.52 percent, it has since ranged from 4.95 to 6.60 percent. This suggests that the recent growth rate of M2 has not been that high by historical standards.
However, money supply growth needs to be considered in the context of the growth of the economy and money demand. Figure 2 presents a more interesting picture by taking the ratio of M2 to GDP for the period 1871 to 2013. From a ratio of just under 0.2 in 1871, the M2 to GDP ratio has grown over time. Recent years have seen it grow to the highest it has ever been. Of course, the period from 1870 to 1930 reflects the growth and development of the modern Canadian financial intermediary sector and monetary sector and the rise in the ratio reflects this. However, the period since 1935 represents the “modern Canadian banking era” in that the Bank of Canada has been in existence during that period.
Figure 3 presents a graph of the trend setting Bank of Canada interest rate and it shows a hump shaped pattern with the lowest interest rates in the period from 1935 to the mid 1950s and since 2009 and the highest rates in the period from the mid 1970s to the early 1990s. On the other hand, since the Second World War, the M2/GDP ratio has shown an approximately u-shaped pattern with lowest M2/GDP ratios in the mid to late 1960s. If the two are juxtaposed as in Figure 3a and taking into account that there is probably a lag between a drop in M2/GDP and the subsequent rise in interest rates, it appears that the peak in interest rates occurs after the low point in the m2/GDP ratio in the late 1960s. If you take the first differences of the M2/GDP ratio and the Bank of Canada rate over the period 1935 to 2013 and plot them against each other (as in Figure 4) and fit a linear trend, you do get a slight inverse relationship. That is, a higher money supply to GDP ratio is correlated with lower interest rates. However, I admit this is a pretty noisy picture. Moreover, this discussion focuses just on Canada and international economic and monetary conditions play a role in the Canadian economy. It would be interesting to see how the performance of Canada’s M2 to GDP ratio over time compares to other countries.
We have been expecting interest rates to rise for several years now because GDP has recovered somewhat from the 2009 financial crisis and the Canadian economy is growing. As a result, one might expect a growing demand for money and credit to fuel rising interest rates. However, money supply – as measured in this case by M2 - is still growing faster than GDP. I think we will see interest rates start to increase provided first that GDP continues to expand and then the M2/GDP ratio starts to drop. However, its not enough that this happens just in Canada – it would also need to happen on a global scale. I don’t think that is going to happen anytime soon. For example, look at Japan.