A prominent Canadian economist is cautioning the Bank of Canada not to be too aggressive with its planned interest rate hikes this year..In a statement in June, the bank’s governor, Tiff Macklem, said the rates need to be in a neutral zone of between 2% and 3%, but indicated he was not averse to taking the rate above the zone in order to fight inflation that now stands at 7.5%..Deputy governor Paul Beaudry echoed the sentiment, saying the bank would need to lift its rate to at least 3% to tame inflation..“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,” says Stephen Brown, senior Canada economist with Capital Economics..“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.”.Survivors of the early 1980s will recall rates soaring to highs never seen before (five-year mortgages at 18%!) resulting in a drastic drop in home values and a major recession..The bank’s rate, increased from .25% in March to 1.5%, has already had an effect on housing markets, says Brown..“Real estate data for May point to a 12% month-over-month fall in national home sales, after the 14% drop in April. While that would leave sales in line with their pre-pandemic norm, the balance between supply and demand looks more worrying,” he says. .“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.The ratio for Toronto specifically points to negative house price inflation.”.Average prices are also in decline.."There was a .6% month-over-month 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 national home prices declined at a similar rate last month,” says Brown..It should be noted average selling prices do not necessarily give a clear picture of market conditions, in this case because sales of higher-priced single-family homes have fallen the most..Although housing is no longer the bank’s primary target, it needs to recognize housing is a major, if not sensitive, factor in its equations..“To be fair to the bank, a housing slowdown is arguably exactly what is required to get the consumer price index (CPI) inflation back toward 2%,” say Brown. “Residential investment is the most elevated component of GDP relative to pre-pandemic norms, CPI inflation for housing related goods and services is much higher than average, and house price declines would also help to pull down certain parts of the shelter CPI.”.Brown suggests there is a good chance the bank will follow through with its hint for a hike larger than .5% in July..In a recent speech, Beaudry suggested the bank's intention of raising its policy rate to the top of its neutral range or taking 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,” said Brown, referencing a period from 1979 to 1987 that raised the US federal funds rate to its highest point in history in an effort to end double-digit inflation..“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 basis points and 350 basis points from their respective lows in September 2021.”.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..“Due to the implications for housing, we continue to struggle with the idea that the bank will hike to 3%, let alone 3.5%,” says Brown. “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.” .“The danger is 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.”
