There is more at risk in Canada's housing downturn than just prices

Tuesday Sep 13th, 2022


There is more at risk in Canada's housing downturn than just prices

Source: Murtaza Haider and Stephen Moranis, Special to Financial Post

The challenge for the Bank of Canada is to determine when to ease off before the economy, not just housing markets, starts to shrink

If ultra-low interest rates were responsible for putting the housing market on steroids, as one prominent economist said in 2020, some might think the steep interest-rate hikes of late will put a chill on the markets, but we should be focusing on more than just prices.

A recent Goldman Sachs Group Inc. paper predicted a housing slowdown in Australia, Canada and New Zealand. Researchers predicted a 13 per cent decline in housing prices in Canada by the end of 2023, and even more drastic declines for Australia and New Zealand, at 18 per cent and 21 per cent, respectively.

The bank predicts lower declines for European economies, with France at six per cent and almost no change in prices in the United Kingdom. As for the United States, it believes prices will rise slightly by 1.8 per cent.

Canadian banks are also predicting housing price declines to stretch to the following year. Desjardins Group, for example, has predicted a 23 per cent decline in prices by the end of next year from the peak levels observed in February. TD Economics predicted a peak-to-trough decline of 19 per cent.

The expected decline in prices should not come as a surprise. Prices have already fallen from their peak values in the first quarter. But let’s keep in mind that housing prices in Canada increased by about 27 per cent in 2021 alone.

Two important lessons could be drawn from last year’s price hike. First, housing prices can never sustain year-over-year growth of more than 20 per cent. This anomalous increase would have reversed eventually without the Bank of Canada’s help.

Second, even a 23 per cent decline in housing prices only brings them back to approximately 2020 levels. But housing prices in Canada have been appreciating fast for much longer. If most Canadians considered prices excessive in 2020, a return to 2020-level prices now or later might not improve housing affordability much.

Indeed, housing affordability may have worsened since prices started to decline. Why? Because affordability depends on both the sale price and a household’s ability to afford the monthly mortgage payments. A steep increase in mortgage rates will increase borrowing costs more aggressively.

No surprise then that the Bank of Canada’s quarterly Housing Affordability Index has shown a steep increase since the first quarter. A higher index value suggests worsening affordability. The Bank of Canada last week increased its policy interest rate by 75 basis points, following a series of increases that started in March. Many believe the central bank is not done yet.

But since housing has become a more significant component of the Canadian economy, a downturn in housing markets can impact overall economic activity. The Goldman Sachs report mentioned that because of a “negative outlook for home prices, and the importance of residential investment and housing wealth, we find that the housing downturn poses larger downside risks to GDP in New Zealand, Australia and Canada.”

The Bank of Canada, in a 2018 discussion paper by economist Taylor Webley, also expressed concerns about housing playing an overgrown role in the economy. The central bank in 2018 found that the level of resale activity was “supported by fundamentals — namely, full-time employment, housing affordability and migration flow” — but it also observed that deviations from a stable relationship between sales volume and economic fundamentals contributed to the growth in housing prices.

Webley’s paper highlighted the risk to GDP growth resulting from fluctuating resale housing markets. Rising interest rates have and will continue to deflate housing sales and prices. This is likely to contribute to a slowdown in the overall economy. The challenge for central bankers is to determine when to ease off before the economy, not just housing markets, starts to shrink.

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