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Canada’s leaders are beefing with the country’s central bank over affordability. Last month, Premiers notified the Bank of Canada (BoC) that rate hikes are making life unaffordable, especially when it comes to housing. The BoC fired back a warning that they shouldn’t be trying to influence a central bank. That’s technically correct, but leaves people with more questions than answers. Had they explained what they do and the basics of data, it would have been clear they’re finally on track. Here’s a basic primer to the drama, monetary policy, and the influence on affordability.
Canadian Premiers Blame The Bank of Canada’s Rising Rates For Housing Woes
Stop me if you’ve heard this one before. Four guys get into an argument—one has a deep understanding of the topic, but no idea how humans work. The other three understand humans, and may or may not care how the topic works. Who do you think the public will perceive as the winner?
That’s this discussion in a nutshell. In September, three Premiers wrote the BoC in an attempt to influence future policy. They all focused on how rising rates increased the cost of living, especially housing.
Two of the three had balanced requests, asking to explore if the BoC had other tools. The other was Premier Doug Ford, who flat out said, “Enough is enough. You’re trying to kill the economy. You personally are responsible for creating inflation.”
Governor Macklem responded in a way typical of a robot trying to appeal to humans. In a letter to Newfoundland Premier Andrew Furey, he acknowledges his concern. He goes on to explain that inflation impacts the most vulnerable, before warning Premier Furey to not try and influence the BoC.
The Governor isn’t wrong. The BoC should have authority independent of political influence. At the very least, it’s needed to maintain the global attractiveness of the currency. Unfortunately, a response like that leads to more questions. Furey asked if there are alternatives in his latest response.
Are the Premiers engaged in political grandstanding? Do they genuinely not understand how monetary policy works? You’ll never know if they understand and are looking to win points with constituents, or if they just don’t get it. What’s important is that you do, so let’s discuss those basics and how they’re working.
Why Would The Bank of Canada Even Move Interest Rates?
The BoC has just one role—to preserve the value of Canada’s money by ensuring low and stable inflation. It’s literally the first thing on the website. Low is relative to the period in history, currently set at 2.0%, plus or minus a tolerance of one point. To achieve this goal, they have one primary tool—interest rates.
When inflation is too low, the central bank lowers rates to entice borrowers. People use borrowed money to buy things, thus stimulating demand. The intentional goal is to overrun supply with excessive demand, resulting in shortages. The shortage creates a non-productive price increase more commonly known as inflation.
If inflation is too high, they raise interest rates to entice savers and pay down debt. By shrinking leverage and rewarding people that don’t spend, they lower demand. Lowering demand helps supply catch up and prevents prices from absorbing excess credit. This works together to stabilize or even lower prices.
Every central bank on the planet found that policy changes take time. More precisely, they found that monetary policy changes take 18 to 24 months to hit the market fully. The first rate hike of this cycle was about 18 months ago, so a good portion of influence is still going to hit the market. National Bank estimates only 57% of existing hikes are reflected in prices at this point.
In short, policy will continue to trickle down and pressure on prices will continue to release. As long as demand isn’t stimulated, this might be all we need. Let’s look at the impact on housing and give a little clarity as to what’s happening.
Canadian Mortgage Payments Aren’t Rising As Sharply As Thought
Housing is the most common complaint we’re seeing in terms of inflation. There’s a few ways to look at this problem, but let’s discuss payments and price today.
Mortgage payments rise as a result of higher financing costs but the impact may not be as big as thought. Equifax data shows the average mortgage payment hit $1,500 in Q2 2023, about 18% higher than they were in 2019. Considering home prices rose 44% over that period, and rents across most of Canada start higher for less space, it’s not what most people expect. Especially recent buyers that have significantly more leverage than existing owners prior to 2021, that think they’re all in the same boat.
It’s easy to understand though. Mortgages last for decades, so most prices aren’t inflated. Buyers over the past few years were the hardest hit, especially if they had no equity. Most new supply is investor-owned and first-time buyers saw their market share shrink over the past couple of years. An investor problem isn’t the same as a household problem.
Canada entered a similar situation to the US in 2008. The narrative was that low income households and first-time buyers lost everything. In reality, investors used subprime leverage, failed, and blew up the global economy. Big difference.
Canada’s CPI Model Skews The Impact of Mortgage Interest On Inflation
We know, but mortgage interest costs are driving inflation! That’s a unique issue in Canada due to the way it measures it. First off, it’s not typical for advanced economies to include interest cost in their CPI measure. The EU and UK don’t include interest costs at all.
Canada does include mortgage interest costs, and it’s amplified by the new CPI model. Mortgage interest saw its basket weight rise 0.85 points to 3.8 points of CPI in 2022. In other words, a dollar increase in 2022 had 29% more impact on the inflation measure than it would have in 2021. It’s a quirk in the CPI model that’s designed to chronically skew inflation lower, but it hasn’t worked yet. Next year it’s likely to be a major driver of lower inflation, even if mortgage costs stay the same.
The impact of higher mortgage rates on inflation is amplified compared to reality. Diving into the numbers, mortgage payments for existing households aren’t a big problem. No one loves it, but it’s not a critical failure waiting to happen. Over inflated home prices? Now that’s a bigger problem, and higher rates are working on solving that.
Low Interest Rates Inflated Home Prices & Moved Housing From End Users To Investors
Central banks traditionally thought that lower interest rates made housing affordable. As most economists do, they assumed the price of a home is detached from credit. Lowering payments meant more free cashflow to stimulate the economy. Boy-oh-boy, were they wrong.
The BoC now admits this was wrong, but only in front of professionals that understand credit. Their research shows low rates didn’t improve affordability over the past 30 years, but fueled higher home prices. Home prices just rose to absorb the additional credit leading to higher home prices. The lower credit went, the higher prices accelerated. They were wrong for 30 years. Whoops.
Unchecked excessive credit always produces bubbles and market inefficiencies. In 2020, rate cuts were made before observing any actual change to inflation. That’s never supposed to happen, and the cuts caused home prices to surge. Raising rates too late made it much worse. Not my opinion, take it up with the BIS—the central bank of central banks. Tiff headed the Governors’ Council at the time.
Leveraging existing assets, investors used cheap credit to bid up prices. End users were pushed out of the market, and investors captured their share. Most new construction is now investor owned, and banks warn investors are replacing first-time buyers. At these prices, investors were depending entirely on appreciation.
Investors have been purchasing homes where rents never covered the mortgage payments. Mortgage interest had little do with the input costs, because these weren’t landlords—they were speculators, betting on short-term appreciation. Input costs never made sense, speculators just have more reason to panic about the dumb decision they made. Lower rates won’t help this problem, it will only reinforce that speculation is a great idea. Inefficiencies breed more inefficiencies.
This occurs with every asset class. The Dutch central bank found that each low rate shock was a transfer of wealth to the rich. The 1% captured a greater share each time. The average person was distracted by a nominal increase, not understanding they were technically worse off.
Now let’s circle back to interest rates needing time to work. If left long enough, it’ll kill speculative fever too. Between the first rate hike in March 2022 and January 2023, the typical home saw an 18% drop in price. That’s about $105k, which despite many people dismissing it as minor, is quite a bit of money. Much more than the average Canadian makes in a year.
It wasn’t until the BoC indicated rate hikes were paused that investors jumped back in. Prices rose until the BoC hiked again, killing that exuberance. After two more rate hikes, Canada’s inventory is now at one of the highest levels in decades. If you believe supply and demand is the most important factor in price, that means further price drops.
In short, expect the exact opposite of what happened over the past 30 years. Well, assuming the central bank can continue to operate without considering public pressure.
Knowing this, Provinces need to make decisions. What’s more important to them—young adults that can’t afford astronomical prices or investors that can’t afford astronomical leverage?
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