Saturday, March 25

Posthaste: Why a 20% plunge in home prices won’t stop the Bank of Canada from raising rates

Good Morning!

Canadians love to talk about real estate, and a big part of that is obsessing over when the ‘big crash’ will come.

“We wouldn’t feel Canadian if we didn’t hear some chatter about the risks that the big bad wolf was going to huff and puff and blow our house prices down,” wrote CIBC chief economist Avery Shenfeld in a recent note.

The latest warning was a podcast interview with Peter Routledge, head of the Office of the Superintendent of Financial Institutions, where he predicted that home prices could fall 10% to 20% in some markets.

But while the “20%” dominated the headlines, less attention was paid to Routledge’s more important conclusion, said Shenfeld — that such a correction would not be such a big deal.

Shenfeld argues that in the pandemic market, home prices in many cities have risen 10-20% in a relatively short time, sometimes in less than a year.

That is too short a time for the wealth gain to have been built into spending plans, so a correction would be “easy come, easy go,” he said.

“Ask yourself how many of your Toronto or Vancouver friends would pare back their spending if their house price reverted to where it was a year ago.”

Home prices too are a “zero sum game” for Canadians as a whole, said the economist. While older homeowners might feel rich when they hear what their neighbour’s house went for, younger Canadians have to save more and spend less on other things to get on the property ladder.

In the end older homeowners often pay for higher housing prices because they are increasingly giving their children money to help with a down payment.

A drop in home prices could also spur economic growth in Canada, a country heavily reliant on immigration to grow its workforce, Shenfeld said.

Expensive housing can be a deterrent to skilled immigrants and businesses looking to locate in Canada might think twice if the high cost of real estate jeopardizes their ability to attract employees, he said.

Shenfeld said it was also notable that the Superintendent of Financial Institutions in that recent podcast saw little risk to the financial system if housing corrects. If home prices fall to where they were a year ago, only those who took out high-ratio mortgages in the past year would find themselves in negative equity, and those mortgages are insured, Shenfeld said. “Loan to value ratios on other mortgages would simply revert to where they were a year ago.”

That’s not to say that a multi-year decline in home prices wouldn’t create “fresh economic fragilities” he said. But for that to happen Canada would have to see a big gain in housing supply, “a longer run for interest rates that overshoots the neutral rate” and perhaps a decline in immigration.

“But a one-time drop that would catch headlines wouldn’t cause the Bank of Canada to lose any sleep over its plans to hike interest rates,” Shenfeld wrote.

Rate hikes are meant to cool demand in areas of the economy that are interest sensitive, of which housing is clearly one. A “painless” rise is one that is not large enough to dent growth thereby helping to contain inflation.

“That said, the household sector’s vulnerability to higher debt service costs as mortgages are renewed in future years does play a role in capping just how high rates have to climb to only decelerate growth, rather than crush it,” he said.