Canada’s real estate bubble may force the country’s central bank to put inflation on the back burner. Yesterday, Bank of Canada (BoC) Deputy Governor Tony Gravelle addressed Quebec economists. In his speech, titled the Perfect Storm, he explained various interest rate scenarios. The one that stood out most was pausing interest rates due to housing debt.
Bank of Canada Neutral Rate
Before we start, you need to know what the neutral policy rate is. It’s the range for the key interest rate, where monetary policy has a minimal influence on the economy. In Canada, this range is for the overnight rate. Above the range, the central bank is trying to cool the market and slow inflation. Below the range, they’re trying to raise inflation via stimulus. Until a central bank hits neutral, it’s unclear what the natural level of demand for goods and services is.
Last month, the BoC raised its forecast for the neutral rate to a range of 2% and 3%, a 0.25 point increase. Most economists see the BoC increasing the overnight rate to 2% by this summer. Yes, the current rate is still at a level that contributes to inflation. That’s why they made the biggest rate hike since 2000, and are expected to do it again at the next two meetings.
Canadian Real Estate May Cause The BoC To “Pause” At Neutral
Earlier this week, RBC warned the BoC might pause rate hikes once they reach the neutral policy rate. They’ll reassess the situation, and then decide if they’ll need to continue higher. Yesterday, the Deputy Governor confirmed that was the plan. Various reasons could impact whether they’ll pause or go past the neutral range. However, the one that stands out is housing — it’s become such a big bubble it may now weigh on the whole economy.
Before we dive in, it’s worth emphasizing again that pausing at the neutral rate is not pausing now. That would still involve double the current overnight rate. It wouldn’t just be higher than when 2020 started, but the highest since the Great Recession. They won’t be providing housing stimulus. However, they are warning they may put inflation on the back burner due to housing debt.
Bank of Canada May Pause Rate Hikes Due To Housing Debt
Housing is one of the main reasons they might pause interest rates at the neutral point. They reminded Canadians how indebted households have made themselves to get into the housing market. At the end of 2021, the debt-to-income ratio was 186%, above the pre-2020 high of 181%. The central bank explained, this will make households more sensitive to interest rates.
“[A factor that] …might lead us to pause is that many households have taken on more debt to get into the housing market,” said Gravelle.
“… rising interest rates are designed to slow the economy by making borrowing more expensive. That tends to slow sectors like housing. But this slowing might be amplified this time around because highly indebted households will face high debt-servicing costs and will likely reduce household spending more than they would have otherwise. Our base-case scenario includes a slowdown in housing activity. But we could see a larger-than-expected slowdown due to higher indebtedness and unsustainably high housing prices.”
In other words, they may tolerate higher inflation if the housing market is in the dumps. It’s an odd take considering the details of the mortgage debt they didn’t share.
Canada’s Real Estate Leverage Is Concentrated In A Small Share of Consumers
Canadians are highly indebted but not as vulnerable as policymakers present. OSFI Guideline B-20 stress tested borrowers for this exact scenario. Borrowers can withstand at least a 2 point hike in their mortgage rate and still only be at a third of their income. This was prudential planning that began back in 2017, so borrowers are prepared. Unless the BoC knows something about the stress test the public doesn’t, it’s a nothing burger.
The debt numbers do sound big and scary, but how many people are we talking about? TransUnion data shows only 29.48% of Canadians with credit accounts have a mortgage. There’s a lot of debt, but it’s concentrated in less than a third of households. The bank regulator previously explained a significant percentage of borrowers are overleveraged.
Mom and pop bought too much house, eh? Remember, the poor don’t have much access to debt. We like to think highly indebted people wear barrels with straps for clothes. In reality, it’s wealthy households that have significant leverage. Asset-rich, income “poor” buyers purchasing investment properties are likely a big share. A billionaire with a $1 salary would have a significant debt to income ratio. So would a retiree using their HELOC to pay off an investment property.
Let’s not downplay the debt issues in Canada — people will borrow obscene amounts of leverage to buy a home. Or two… or 16. But the distribution of this debt makes more sense than using it as a national warning. If it’s not an issue that impacts most homes, using a broad tool like monetary policy makes little sense. Regulatory or political tools are much better options. It’s the same reason you kill a fly with a swatter and not a bazooka — to avoid the collateral damage of solving a small issue.
Canada’s Mortgage Borrowers Aren’t As Vulnerable As Presented
Households will see their payments rise but how much are they paying, anyway? We see high home prices and fail to realize most homes were bought before prices surged. According to TransUnion data, the average mortgage payment in Q4 2021 was just $1,380/month. It’s lower than the average rent for a 1-bedroom across Canada. Borrowers are also paying less interest than inflation, which is a gift. Somehow taking away that gift is considered a punishment.
If a household also can’t handle higher payments, they still have options. Extending the amortization is a very common one, even as rates were falling.
“But what about the recent homebuyers?,” is what every real estate salesperson wants to yell. Since 2021, about 44% of mortgage debt at institutional lenders was issued. Less would have been issued if rates climbed last year when they were supposed to, but that’s another post.
A third of the new debt issued was locked in at fixed rate terms of 5-years or longer. They are locked in at record low rates, and won’t be impacted for years. OSFI’s B-20 stress test vetted the rest, but let’s say they’re the only ones vulnerable. That’s only a third of all mortgage debt outstanding. These are BoC data points, so it’s surprising they wouldn’t know this and present the data.
Putting it all together, the fact the central bank would consider a pause just due to housing is wild. A pause due to ~9% of mortgage borrowers potentially seeing a third of their income impacted. It’s also likely less, since a third of buyers in pricey markets like Ontario are deep pocketed investors. To save these folks, Canada is willing to embrace more price instability and see the decay of 100% of the population’s money? Good grief.
