It is unfortunate that the Bank of Canada’s next interest rate decision will not be accompanied by a Monetary Policy Report. Given what has occurred since their last update, it would have been entertaining to see them square the circle.
When we last heard from the head Sage of Sparks Street, he was stressing the precarious position of the Canadian economy given the potential downsides of a Trump presidency and downplaying any positive effects that may be straying across the border from a stronger US economy. The Governor appeared petrified to even give a hint of optimism for fear that a resulting stronger Canadian dollar could take inflation further below its target.
Subsequent to those comments, the trade numbers came in better and employment defied gravity, leaving little doubt that the economy has performed better than they had anticipated.
But maybe the most important development since the last MPR is what is happening in the housing market. By many standards, real estate prices appear out of control and some pundits have dared to utter the word “bubble”. This has been a perennial concern for the Bank in their Financial System Review but that has not stopped them from keeping the flame burning under the dry kindle hoping inflation would pick up before the wood ignited. It appears the wood has caught fire.
In their more recent monetary policy reports, however, they have insisted that any corrective macro prudential actions taken in response to the housing market are best placed in the hands of our elected officials and their agencies. This allows the Bank to focus on delivering the appropriate policy rate that will solely achieve their inflation target, even if that means over stimulating one sector of the entire economy. By shunning responsibility to dampen any housing bubble, this frees up the Governor to express his dismay at rising Canadian yields and a “too strong” dollar, as he did at the last MPR.
The Bank constantly reminds us that monetary policy is a blunt tool, inappropriate to use to address any potential housing crisis, especially when housing prices are acting very differently in different parts of the country. Can they continue to take this tact, relying on politicians to do the right thing, or is it time that this factor get more weight in their monetary policy decision going forward?
It’s true that ever rising real estate prices in Vancouver have stalled and are declining following the imposition of a tax on foreign buyers by the provincial government, leaving sky rocketing Toronto housing prices as the outlier. The problem is that Toronto housing prices are starting to spillover into cities that require over an hour and a half commuting time. The dramatic price increases are no longer confined to single family homes in a city of 2.5 million, but are now spreading to impact a population approaching 8 million people. Unlike in BC, where just over 1 million people were being impacted, this is now closing in on 25% of the Canadian population that will make it necessary to devote more of their disposable income and commit to greater amounts of leverage if they want to become home owners.
Apart from the financial vulnerability that this represents, it also brings with it economic vulnerability. As a first year economics text book will tell you, labour and capital in the economy get allocated by the pricing mechanism. Much like higher oil prices spurred a huge reallocation of labour and capital to Alberta that is now being painfully unwound, higher and higher prices in residential investment in Ontario are sucking up resources. It is no coincidence that one of the strongest contributors to employment growth over 2016 came from finance/insurance/real estate and leasing. Construction was up there as well.
To digress a moment. It seems inconsistent to be concerned about the economic vulnerability created by the hollowing out of our economy when an inappropriately strong dollar causes firms in the export sector to close, but it is okay to encourage a build up in economic activity concentrated around just one sector as a result of an inappropriate interest rate level. Both create vulnerabilities.
More worrisome for the economy in the longer run is that our resources are “temporarily” being used to support and create non-productive assets. When the music stops and the air comes out of this bubble, you will be left with an asset that really can’t be used for anything productive. At least the tech bubble left us some infrastructure for communication and funded some worthwhile research and development.
Already in a low interest rate environment, there is little incentive to invest into productivity enhancing real tangible assets. Why on earth would any rational economic agent invest in a small start-up anywhere in this country when the easiest way to make money obviously is to lever up and buy a couple of homes in the GTA?
But for the Bank of Canada, the good news is that none of this needs to be addressed directly this time. And with some timely macro prudential action from the Department of Finance and the Ontario government, this topic may never have to make it back to the MPR forum. They can stick to do what they do best. (I am no political analyst but with talk of the federal government thinking of increasing taxes, shocking electrical bills in Ontario and long hospital waiting times, taking action now to reduce home owners’ wealth would seem to require a level of political focus and will that may not be there yet.)
So as the Bank has continually done, by ignoring the elephant in the room, the press release will be much the same. They will acknowledge that the economy is a bit better than previously thought but that it is not yet out of the woods. The volatility of the trade numbers have fooled them before and Trump and his trade policies are still lurking out there in the future. The risks to inflation are balanced but the downside ones will be in italics. They will remind us that core inflation (take your pick from their extensive menu) remains below their 2% target and that the economy continues to have considerable excess capacity. Despite real world evidence that things may not be that bad, and the glass may be half full, expect to see another press release with Eeeyore’s paws all over it.
And one final thought in this world of monetary policy decisions being made in a risk management context. The Bank loves to talk about vulnerabilities and risks, their favourite analogy being a tree with a large crack in the trunk. This makes the tree vulnerable, but it is not until a storm comes along that the tree topples over and potentially causes damage. The housing market is vulnerable and its “crack” is getting larger by the day in an economically significant part of the country. The Governor is continually telling us that the makings of a huge storm is possible given the potential trade policies of the Trump administration. Is it proper public policy to continue to ignore the expanding housing vulnerability at the same time that you believe there is a heightened downside risk to the economy over the next few months? At the very least, for the next while, and with one eye on the housing market, maybe its time to drop any talk of interest rate cuts potentially being on the table.
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