Canada's Housing Bubble

Sep 13, 2010 Michael Babad theglobeandmail.com

Did the Bank of Canada fuel house price appreciation?

The Bank of Canada may have fuelled the run-up in Canadian house prices with loose monetary policy over the course of the last decade, the Organization for Economic Development and Co-operation says. In its annual review of the Canadian economy, released today, the group notes the increase in house prices, along with the price-to-income ratio, since the late 1990s, with a time out starting in June 2008 when costs fell, but only briefly. Some markets, the OECD says, are still overpriced despite the recent softening in the market, though real estate is expected to soon cool further.

"The price of an average home recently reached five times average household after-tax income, which is 35 per cent higher than the long-term average of 3.7," the OECD says. "... One factor that may have fuelled the sustained appreciation is relatively loose monetary policy over the 2000s, though this hypothesis is controversial ... On the other hand, some studies suggest that the sustained house-price appreciation represented a catching up of prices with their long-term determinants and that they are now broadly in line with fundamentals."

On the controversial part, the OECD cites what a formula known as the Taylor rule, or Taylor's rule, which was built by Stanford economist John Taylor. The Federal Reserve Bank of San Francisco says the rule was developed to provide recommendations for how central banks should peg short-term interest rates as conditions change. Without going into details of the complex formula, the idea is to meet central bank goals for both stabilizing the economy in the short run and containing inflation in the long term.

The Bank of Canada would not comment on the OECD report but pointed to a statement last April, when it cited the fact that it lowered its benchmark interest rate quickly to a record low over 2008 and into early 2009, and provided markets with a conditional commitment to keep it there. "This unconventional policy provided considerable additional stimulus during a period of very weak economic conditions and major downside risks to the global and Canadian economies. With recent improvements in the economic outlook, the need for such extraordinary policy is now passing, and it is appropriate to begin to lessen the degree of monetary stimulus.”

And in July, it projected investment in housing would weaken this year and well into next, reflecting "the significant amount of activity that was moved forward in late 2009 and early 2010 by exceptionally low mortgage rates and the recently expired home renovation tax credit, together with tighter mortgage affordability and higher house prices.”

Actual and Taylor-rule-based policy interest rates

"OECD research has found that conventional monetary easing, when interest rates are brought well below Taylor rates and are maintained there for an extended period of time, is frequently followed by the build-up of financial imbalances in housing markets," the OECD said. "... While the correlation is only suggestive, the time during which the Bank of Canada maintained its policy rate significantly below the Taylor-rule rate for an extended period lines up perfectly with the period of sustained real house price appreciation over the last decade ... It must however be noted that from 2002 to 2008, monetary conditions were tightening due to the sustained Canadian-dollar appreciation."

Canadian, U.S. home prices

The real estate sector has been softening but Ottawa may need to do more to cool the mortgage market, the OECD added. It added that it expects house prices to “come under downward pressure” soon as interest rates and income growth slows. “Like other OECD countries, Canada is probably entering a fairly long period of relatively slow household income growth,” the group said.

Canadian household debt

OECD warns on high debt levels

In its lengthy report, the OECD also warned about high levels of consumer debt and the increasing threat to some people who may be in over their heads as interest rates rise. At the same time, it said, household income growth will probably slow.

As a proportion of disposable income, household debt rose markedly over the past decade, reaching close to the OECD average by 2008, the group said in its annual review of Canada. Levels continued to climb during the recession, driven largely by mortgage debt given the rebound in the housing market.

“Healthy credit expansion” was a goal of the Bank of Canada to fight the recession, and record low interest rates have brought down the proportion of disposable income needed to service debts, the OECD noted. “That being said, the upward trend in the debt ratios implies that households have a growing vulnerability to additional adverse shocks,” it added. “For example, if households continue to borrow at the same pace as they did recently and interest rates increase as expected, by mid-2012 about 7.5 per cent of Canadian households could have so much debt that they would be ‘financially vulnerable,’ up from 6.1 per cent in 2009 ... This group is likely to include many young, first-time home buyers that have been profiting from low mortgage rates.”

Net worth falls for first time since recession

More on that front: The net worth of Canadian families fell in the second quarter of the year for the first time since the depths of the recession, pushed down by the drop on North American stock markets. Household net worth dipped 0.6 per cent, or $34-billion, to $5.9-trillion, marking the first decline since the first quarter of last year, Statistics Canada said today. "Increases for some financial assets, especially deposits, were more than offset by declines in equities, foreign investment and life insurance and pension assets," the statistics gathering agency reported. "Households equity holdings declined for both marketable shares as well as mutual funds."

Statistics Canada noted the 6.2-per-cent drop in the S&P/TSX composite index, after four quarters of increases.

It noted that liabilities, largely mortgages and consumer credit, increased, though the ratio of household credit market debt-to-personal disposable income fell for the first time since early 2006, to 143.7 per cent. The debt-service ratio also fell, both due partly to an increase in personal disposible income. But debt-to-net worth rose after falling for four quarters. That will be felt, economists say.

"Weak asset growth in combination with still strong liability growth will likely have households feeling buried under more debt than they ever have," said Toronto-Dominion Bank economist Diana Petramala. "Households will likely feel a need to constrain spending and repair the damage done to their balance sheets. As such, quarterly consumer spending growth is expected to remain in a range of 2-2.5 per cent over the next year, well below the 3.5-4 per cent growth registered over the last five years. "

Read also: The Canadian family: Deep in debt, net worth slipping