Bank of Canada rate hike could cost Canadians billions in government debt interest
The Bank of Canada recently raised its policy interest rate by half a percentage point, which is the largest rate hike since 2000. While the rate hike is meant to combat inflation, it also has important implications for the government finances across Canada.
In the decade prior to the pandemic, Canadian governments collectively accumulated approximately $525 billion in net debt despite a growing national economy in nine of the 10 years. COVID-19 then exacerbated the problem, as governments increased spending and amassed hundreds of billions in additional debt during 2020 and 2021. In its recent budget, the federal government alone projects net debt will surpass $1.3 trillion this fiscal year (2022/23) and continue climbing until at least 2026/27.
The burden of government debt falls on Canadian families today and in the future. Like households, governments must pay interest on their debt, which is ultimately paid by Canadians in the form of taxes. Servicing the debt also diverts resources away from services such as health care and education.
Federal debt interest costs alone will hit a projected $26.9 billion (or $696 per person) in 2022/23 and increase to $42.9 billion (or $1,065 per person) by 2026/27. On aggregate, interest payments on federal debt will cost Canadian taxpayers roughly $180 billion during that period.
As the Bank of Canada raises interest rates, all else equal, government debt interest costs also rise. The federal budget does bake some interest rate hikes into the fiscal plan, as private-sector forecasters were anticipating rates to increase gradually over time. However, if for example the effective interest rate on government debt rose one percentage point higher than forecasted, annual interest costs on federal debt would jump from $42.9 billion to $52.2 billion by 2026/27, an increase of $9.3 billion in a single fiscal year.
The debt interest burden for Canadians doesn’t end there. Many provincial governments across the country borrowed heavily both before and during the pandemic, contributing to significant increases in debt interest costs at the provincial level.
Take Alberta, for instance. Not long ago, the province’s debt interest costs were negligible—in 2008/09, they were just $58 per Albertan. The province will incur a projected $2.7 billion in debt interest costs this year, equal to $591 per Albertan. Needless to say, that interest bite is growing larger by the year.
Finally, higher debt interest costs can contribute to larger budget deficits. And any further deterioration in federal and/or provincial finances could lead to further downgrades in the debt rating for Canadian governments and an increased risk premium attached to our debt. Canada experienced this vicious cycle of larger and larger budget deficits and more debt accumulation during the 1990s debt crisis when interest costs on federal debt consumed one out of every three dollars of government revenue instead of going towards services for Canadians.
Clearly, as the Bank of Canada hikes interest rates in an effort to reduce inflationary pressures, governments across the country should exercise caution with their borrowing and spending. Otherwise, Canadian taxpayers will pay a significant price.