Monetary Policy and Financial Stability: Canada's House-Price Dilemma

IMF Blog, March 21, 2016

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Canonical URL: Monetary Policy and Financial Stability: Canada's House-Price Dilemma

National house prices in February show a year-on-year increase of 9 percent.
Vancouver and Toronto—cities that contribute about a third of Canada’s GDP—have led the house-price increase.
Canada’s household debt rose to 165 percent of disposable income by the end of 2015.
Alberta: house prices fell by 4 percent since their peak in late 2014 amid an economy expected to have contracted by almost 2 percent last year.

Low mortgage rates have kept interest payments low even as average mortgage size increased by some 40 percent between 2008 and 2015.
The share of interest payments in households’ disposable income declined from 9 percent in 2008 to 6 percent in 2015.
Mechanism described:
- Low rates → lower interest burden → households afford more expensive homes → households borrow more → household debt rises → house prices pushed upward.
- This process is expected to continue as long as employment is robust and interest rates remain low.
Greater housing wealth supports private consumption, which helped the economy grow by 1.2 percent in 2015 and offset a recession in the first half of the year caused by a sharp decline in business investment in the resources sector.

Raising interest rates could cool the housing market and slow household borrowing, but would also:
- Hurt borrowers and the broader economy, which was already weakened by the oil-price shock.
- Increase unemployment and reduce GDP growth in the near term.
Cutting the policy interest rate in response to the oil-price shock (the Bank of Canada’s action) is supported by recent analysis given the weak economic context.

Timing of effects:
- Benefits in reducing household debt accrue slowly, peaking 8 years after the monetary policy action.
- Costs in the form of higher unemployment are paid upfront within the first two years.
“Lean against the wind” (raising interest rates beyond price-stability needs) is justified only if:
- Credit grows excessively fast (more than 9 percent annually), and
- The cost of a financial crisis is severe.
Comparative quantitative estimates for a 100 basis points monetary policy contraction:
- Effect on household debt after 5 years: the authors find a reduction of 1.25 percent versus the Bank of Canada’s estimate of 2 percent.
- Effect on GDP growth: the authors find a reduction of 0.75 percentage point versus the Bank of Canada’s estimate of 1 percentage point.
Considerable uncertainty surrounds these estimates, but they align reasonably with the Bank of Canada’s own assessments.

For the time being, a cautious, judgment-based approach to monetary policy is warranted in the face of competing objectives (price stability, macroeconomic weakness, and rising household debt).
Macroprudential policies and measures should be the first line of defense in addressing financial stability risks, complementing monetary policy.
The IMF will continue assessing the effectiveness of macroprudential measures in Canada (detailed discussion beyond the scope of the summarized working paper and blog).

IMF blog post by Cheng Hoon Lim, March 21, 2016.