## 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](https://www.imf.org/en/blogs/articles/2016/03/21/monetary-policy-and-financial-stability-canadas-house-price-dilemma)

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## Bibliographic details
- Authors: Cheng Hoon Lim
- Published: March 21, 2016

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### Housing market dynamics and immediate challenge
- 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.

### Mortgage rates, household balance sheets, and consumption effects
- 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.

### Monetary policy dilemma and trade-offs
- 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.

### Findings from Pescatori and Laseen (working paper summarized)
- 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.

### Policy implications and recommended approach
- 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.*

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## References

- [paper](http://www.imf.org/external/pubs/cat/longres.aspx?sk=43811.0)
- [Andrea Pescatori](https://blogs.imf.org/bloggers/andrea-pescatori/)
- [Stefan Laseen](https://blogs.imf.org/bloggers/stefan-laseen/)

_Source: https://www.imf.org/en/blogs/articles/2016/03/21/monetary-policy-and-financial-stability-canadas-house-price-dilemma_