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Bank risks sending housing into a tailspin

  • The Bank of Canada’s recent communications suggest that it will be unfazed by the second consecutive double-digit drop in home sales in May. This raises the chance of the Bank enacting a larger interest rate hike at its meeting in July and leaves us concerned that it will take a more aggressive approach to policy tightening than is ultimately required, driving house prices sharply lower and risking a major recession.
  • The local real estate data for May point to a 12% m/m fall in national home sales, after the 14% drop in April. While that would leave sales in line with their pre-pandemic norm (see Chart 1 overleaf), the balance between supply and demand looks more worrying. The sales-to-new listing ratio for Canada’s four largest cities now implies that house price inflation will drop to zero by the end of 2022, from 18% in April. (See Chart 2.) The ratio for Toronto specifically points to negative house price inflation. (See Chart 3.)
  • In reality, prices are already falling. There was a 0.6% m/m drop in nationwide home prices in April and, with average selling prices in Toronto falling by more than 3% for the second consecutive month in May, it seems likely that national home prices declined at a similar rate last month. (Average selling prices somewhat overstate the weakness because sales of higher priced single-family homes have fallen the most.)
  • None of this seems to be concerning the Bank. In its policy statement last week, the Bank dedicated just one sentence to housing, arguing that “housing market activity is moderating from exceptionally high levels”. In his 2,700 word economic progress report the next day, Deputy Governor Paul Beaudry didn’t even mention the housing market. Accordingly, following its 50 bp interest rate hike this month, there is a good chance that the Bank will follow through with its hint for an even larger hike in July. (See here.)
  • To be fair to the Bank, a housing slowdown is arguably exactly what is required to get CPI inflation back toward 2%. Residential investment is the most elevated component of GDP relative to pre-pandemic norms (see Chart 4), CPI inflation for housing related goods and services is much higher than average (see Chart 5), and house price declines would also help to pull down certain parts of the shelter CPI. (See here.)
  • The danger, however, is that the Bank will misjudge the impact of its aggressive policy tightening. While home sales react relatively quickly to higher interest rates, it will take several quarters for the full effects on house prices and broader activity to be felt. For example, in the US before the global financial crisis, sales began to weaken in 2005 and housing starts followed suit in 2006, but it was not until 2007 when that weakness spilled over to the rest of the economy and house prices started to fall even more sharply. The risks look particularly pronounced because household debt is even higher than it was in the US in 2007.
  • In his speech last week, Beaudry suggested that the Bank now intends to either raise its policy rate to the top end of its neutral range estimate – of between 2% and 3% – or take it above that range. If the Bank raised its policy rate to 3.5%, which is only slightly above the current market implied terminal rate of 3.25%, then the housing market would face the most dramatic hit to affordability since the early 1980s Volcker Shock. By our estimates, a policy rate of 3.5% would result in an average five-year fixed mortgage rate of 4.5% and an average variable rate of 4.9%, up by 240 bp and 350 bp from their respective lows in September 2021. (See Chart 6.) Even allowing for an acceleration in wage growth this year, an average of those mortgage rates would reduce the maximum house price that a buyer could afford by 23% compared to last year, four times as large an impact as during the prior three tightening cycles. (See Chart 7.)
  • Worse still, house prices were more stretched at the start of this tightening cycle than any before it. Based on a policy rate of 3.5% and a five-year fixed mortgage rate of 4.5%, a median income earning household committing one third of its pre-tax income to mortgage payments would have a budget of $525,000. At the end of the first quarter, the average house price had surged to be 67% higher, at $875,000. (See Chart 8.)
  • Due to the implications for housing, we continue to struggle with the idea that the Bank will hike to 3%, let alone 3.5%. But with policymakers intent on hiking so rapidly, we may be forced to raise our forecast for the terminal policy rate, from our current assumption of 2.5%, regardless. If so, we would also forecast a steeper decline in house prices than our current assumption of a 10% correction and, rather than GDP growth slowing only to below its potential next year as we currently expect, there would be a real risk of recession. (See Canada Economics Focus, “Will a housing downturn crash the economy?”.)

Chart 1: Home Sales (000s)

Chart 2: Sales-to-New Listing Ratio & Average House Prices for Toronto, Montreal, Vancouver & Calgary

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Chart 3: Toronto Sales-to-New Listing Ratio & House Prices

Chart 4: Components of GDP (% change,
Q1 2022 vs Q4 2019)

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Chart 5: CPI Inflation (%)

Chart 6: Mortgage Rates (%)

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Chart 7: Peak-to-Trough Impact on House Price Affordability During Historical Tightening Cycles (%)

Chart 8: Housing Affordability ($000s)

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Sources: Local RE Boards, Refinitiv, Robert McLister; Interest Rate Analyst


Stephen Brown, Senior Canada Economist, stephen.brown@capitaleconomics.com