A Central Bank’s Dilemma: Should Monetary Policy Be Used To Curb A Housing Boom?

Canada is experiencing the twin monetary challenges. Household indebtedness is at an all -time high, while housing prices continue their relentless upward surge. The big challenge for the Bank of Canada is: can it use monetary tools to tackle the housing boom without causing collateral damage? Should monetary policy be used to bring housing prices back in line with long term trends?

Chart 1 maps the dramatic rise in Canadian household debt-to-disposable income ratio. In the United States, the ratio took a dramatic downturn after the 2008 financial crisis. Canadians , however, were not so inclined to de-lever ; in fact, we just continued to increase our debt ratio to new heights.

Chart 1

The steady increase in household debt was driven by a sharp and sustained increase in house prices, abetted by very low interest rates and an ample supply of mortgage and home equity loans. (Chart2). Nationally, home prices have surge by 12 per cent from last December, marking the 10^th straight record-breaking month. Overall, home prices in Canada have doubled since 2005. There has been a lot written on the extent to which Canadian housing costs are ‘over-valued’. We know that there are significant population pressures pushing up housing costs¹, yet we cannot rule a certain element of speculation. Nonetheless, we are faced with a very strong housing market, whether one considers it a bubble or not.

Chart 2 Year –over-year House Price Increases, 2015-2016 (Nov)

A combination of very high household debt and over-valued house prices puts the Bank of Canada in a difficult position. The Bank must walk a tight rope, featuring, on one side, too much leverage and ,on the other side, an inflated asset that is at the heart of consumer wealth. It must avoid policy moves designed to reduce debt ratios without precipitating a housing bust that brings with it a lot of collateral damage--- witness the U.S. housing collapse in 2008 . Financial stability must be preserved at all cost.

Recent research at the Bank of Canada examined the question should it "lean" against a housing boom. Their analytical model concluded that :

“leaning <against> leads to reduced levels of debt, hurting borrowers, who partly rely on leverage to finance their consumption and housing expenditures.” ²

It seems that household wealth and household consumption are very intertwined. Thus cost of curbing house prices with conventional monetary policy tools is simply too high, suggesting that central banks should not lean against housing booms.

So far, the Bank has resisted raising the bank rate to temper housing inflation. The benchmark Canadian bond rates have experienced some yield increases, in response to the rise in bond yields in the United States. Thus, one could claim that the Bank is allowing market conditions to tightened mortgages and housing costs. Although to date, mortgage rate increases have been, largely, de minimis. Given the general weakness in the economy, the Bank would be very loath to introduce a bias towards raising the bank rate. However the Bank continues to use moral suasion to warn Canadians about the risks of increasing debt ratios. In the meantime, we should not anticipate the Bank taking any explicit moves to moderate the housing demand.

1^ Canadian Economy 

2^ Sami Alpanda and Alexander Ueberfeldt , “Should Monetary Policy Lean Against Housing Market Booms? “ April , 2016