(Bloomberg) -- The old debate about whether central banks should raise rates to counteract housing bubbles is finding new life in Canada as the country copes with record prices in its two biggest real estate markets.
Toronto home prices were still up almost 30 percent last month, compared with the previous year, the city’s real estate board reported Monday, and have more than doubled since the 2008-2009 recession. In Vancouver, the country’s most-expensive real estate market, they’ve climbed 58 percent over four years. Meanwhile, household debt is at record levels, recently surpassing gross domestic product for the first time.
Lawmakers at every level have tried with a succession of tailored policies to engineer a slowdown, but have fallen short of achieving the desired effect.
Could now be the time for the Bank of Canada, which releases its bi-annual analysis of financial stability risks Thursday, to step in with higher borrowing costs to “lean against” the bubble, even at the expense of its inflation target?
Don’t bet the house on it.
The Bank of Canada looks at financial stability through two separate lenses.
- The central bank’s primary objective is to adjust interest rates to keep inflation as close to 2 percent as possible. Financial imbalances, along with other moving parts such as trade, business investment and oil prices, factor into the decision making. For example, policy makers would consider the effect a sharp housing correction would have on consumer spending.
- The bank also considers financial stability outside the context of macroeconomic objectives, because the economy can’t function properly without a stable financial system. Indeed, the bank acknowledged in 2011 that in some circumstances, preemptively leaning against a build up of debt would be beneficial, even if it meant missing its inflation target temporarily.
The distinction matters for policy.
When the primary concern is financial stability, the direction of policy is clear in the face of growing debt and financial imbalances; interest rates should be on the way up since cheap credit fuels household borrowing. From 2011 to 2013, the central bank addressed existing financial stability concerns in this way, by incorporating explicitly into policy first a tightening bias and then a reluctance to cut rates.
In fact, the focus on financial stability was controversial in government circles at the time and a source of friction between then Bank of Canada Governor Mark Carney and former Prime Minister Stephen Harper as the economy teetered on the verge of another recession in 2012. At the time, Carney was alone among Group of Seven central bankers to cleave to a tightening bias and, as a result, Canada’s currency continued to trade above parity with the U.S. dollar, slowing growth.
When the inflation target is the main policy impetus, things get messier.
Sometimes, inflation and financial stability concerns call for the same action. For example, if a red hot housing market leads to higher inflation, it’s a textbook case for central bank tightening.
Often, the two objectives conflict. A weaker economy would necessitate low interest rates, which in turn fuel financial imbalances. That’s where the central bank is today -- unable to keep inflation at the 2 percent target over the past two years in an economy it says still has plenty of slack.
Raising interest rates to thwart an asset bubble would simply force the rest of the country to suffer for the excesses of Toronto and Vancouver housing markets.
“From the Bank of Canada’s perspective, what you have is a potential financial stability concern that isn’t explicitly part of the bank’s inflation targeting framework, while inflation remains well below target,” said Jean-Francois Perrault, chief economist at Bank of Nova Scotia.
- Toronto home sales (Monday, 5 a.m.)
- Bloomberg Nanos consumer confidence index (Monday, 10 a.m.)
- Housing starts (Thursday, 8:15 a.m.)
- New housing price index (Thursday, 8:30 a.m.)
- Bank of Canada Financial System Review (Thursday, 10:30 a.m.) and Poloz press conference (11:15 a.m.)
- Jobs report for May and first-quarter capacity utilization rate (Friday, 8:30 a.m.)
Since the oil price collapse in 2014, there’s been little debate on the issue. Policy makers at the central bank have been more concerned with getting inflation higher with lower rates, leaving regulators to tackle the financial stability issues.
So, now that Canada has emerged from the oil shock, does financial stability resurface as a driver of monetary policy?
The central bank’s own research hasn’t supported such a shift. A study published last year showed higher borrowing costs reduce financial vulnerabilities only modestly, and impose large costs on the rest of the economy.
The central bank also distinguishes household indebtedness from the housing market, which allows it to worry less about rising home prices that are driven by factors such as population growth or supply constraints, as opposed to debt accumulation. And the recent run-up in home values hasn’t been accompanied by an equivalent run-up in credit growth.
The Bank of Canada has stopped mentioning the issue in its closely parsed rate statements. The last time the term “household imbalances” appeared was in the Dec. 7 statement. And there is evidence the market is cooling already on the back of recent measures by the Ontario government, and the troubles at alternative mortgage lender Home Capital Group Inc.
Poloz has even dismissed the idea that higher borrowing costs would reduce the sort of speculative demand that seems to be prevalent in Toronto and Vancouver.
“They haven’t said anything to suggest financial stability considerations would trump the inflation objective,” Perrault said.
Most indicative may be that Poloz has actually turned the financial stability argument on its head. Higher-than-needed interest rates would not only slow the economy, they would even be bad for financial stability by increasing the financial stress of highly indebted households.
This was part of the rationale for cutting rates twice in 2015. And it’s another way of saying that with household debt levels where they are, it’s already too late for the Bank of Canada to lean in.