OECD Warns of Half-Point Interest Rate Hikes Amid Rising Real Rates

The Organisation for Economic Co-operation and Development (OECD) forecasts that interest rates will rise by half a point in most countries, including Canada, over the next year. This follows recent hikes by major central banks such as the U.S. Federal Reserve, the European Central Bank, Japan, and New Zealand. The OECD's prediction comes after experts previously suggested that interest rates could fall due to economic stagnation.

Inflationary pressures are driving up interest rates. In 2022, headline inflation peaked at over eight per cent in the EU, U.S., and U.K., while Canada saw a peak of six point eight per cent, largely due to excessive COVID-19 spending and accommodative monetary policy. However, since then, inflation has fallen to around three per cent in many countries, excluding energy and food prices, which are closer to two and a half per cent.

The OECD attributes ongoing inflationary pressures to factors such as tariffs, the Ukraine-Russia war, and oil price shocks. Additionally, private investment in artificial intelligence is boosting demand for capital and labor, offsetting expected losses in GDP from tariffs and higher energy prices. Housing shortages are also driving up construction and land costs, while diesel price increases are affecting food and other transported products.

While inflation is a significant factor influencing interest rates, something else is now at play: rising real interest rates. Real interest rates are the nominal interest rate minus expected inflation, covering patience and risk costs. The U.S. 10-year bond sold at an average interest rate of two point nine five per cent in 2022, while its inflation-protected counterpart paid roughly seven-tenths of one percent, implying a forecasted inflation rate of two point twenty-five per cent over ten years.

In contrast, by 2025, the average interest rate on U.S. 10-year bonds was four point two nine per cent, with inflation-protected bonds paying two point two per cent, indicating an expected inflation rate of two point one per cent. This suggests that interest rates are rising due to a significant increase in real rates, rather than a change in long-term inflation expectations.