Introduction to Canada’s Real Estate Situation
Canada’s real estate market has been a topic of discussion for years, with prices skyrocketing and concerns about the market’s stability. The Bank of Canada (BoC) recently cut its overnight rate by 25 basis points to 2.50% at its September meeting, which was expected. However, BMO economists are warning that moving too fast with rate cuts could undo the recent housing market stabilization and reignite exuberance.
Understanding Real and Negative Interest Rates
Before diving into BMO’s warning, it’s essential to understand two key financial concepts: real interest rates and negative real rates. The real interest rate is the inflation-adjusted interest rate, calculated by subtracting inflation from the nominal rate. With the overnight rate at 2.5% and headline inflation at 1.9%, the real rate is 0.6%—barely above zero. Negative real rates occur when inflation exceeds the nominal rate, making debt cheaper over time.
Measuring Inflation
An overlooked question is how inflation is measured. Headline inflation gets the most attention, but it’s volatile. The BoC prefers to use core inflation measures that were much higher in August: CPI-common (2.5%), CPI-trim (3.0%), and CPI-median (3.1%). By these metrics, the real rate is already at or below zero. This raises concerns about the accuracy of inflation modeling and whether it captures the actual rate of inflation.
Canada’s Housing Obsession Fueled by Easy Money
The narrative of Canadian real estate’s epic multi-decade price growth is heavily debated. While many factors contribute to this growth, cheap credit is the primary driver. BMO Canadian Rates & Macro Strategist Benjamin Reitzes notes, "Housing has been a Canadian obsession for at least two decades, with ultra-low rates providing jet fuel to the market since the GFC." The abundance of cheap credit has fueled the housing market, making it sensitive to changes in interest rates.
Canadian Real Estate Prices and Interest Rates
Canadian home prices have benefited from plunging rates stimulating borrowing for at least two decades. When rates were cut to nearly zero in 2020, the market went into hyperdrive, despite population growth stalling. However, as rates rose to healthy levels, home sales and prices plummeted, despite record population growth. Reitzes explains, "A normalization of interest rates has prompted some sanity to return to the market with a decent amount of froth coming out of prices." He suggests that the BoC consider the delicate balance, as cutting rates too far could reverse this progress and stimulate excessive market activity.
The Risks of Negative Rates
The bank warns policymakers to consider drawing a line at real negative rates, or even nominal rates with a "1-handle." Slashing rates below this key level is likely to serve as a psychological trigger for buyers and investors. Reitzes warns, "A return to negative real rates and/or nominal rates with a 1-handle will likely spark renewed housing exuberance that policymakers… should not want to see." This would run contrary to the cautious tone and government policy goals, and could lead to a housing bubble.
Conclusion
In conclusion, Canada’s real estate market is heavily influenced by interest rates, and the BoC’s decision to cut rates must be carefully considered. While rate cuts may offer short-term relief, they threaten housing stability, future affordability, and the economy’s long-term prospects. BMO economists warn that the BoC should be cautious not to reignite the housing bubble, and that negative real rates could have devastating consequences. As the BoC continues to navigate the complex world of monetary policy, it’s essential to weigh the risks and consider the long-term effects of its decisions.
