July 8, 2012


Title: BOC off the hook?

Sub-title: Mortgage rule tightening should enable the central bank to keep its policy rate low…for now.


Last week’s Canadian and US employment data confirmed what many economists have long suspected: the recovery, while intact, remains fragile. That puts the Bank of Canada, which has been worried about rising consumer debt levels, in an awkward position. While Mark Carney, its governor, is thought to favour an interest rate hike to cool excess housing sector related borrowing, he remains reluctant to do so, for fear of damaging other parts of the economy. 


However the recent tightening in mortgage lending requirements announced by finance minister Jim Flaherty may have let Carney off the hook. As Craig Alexander, chief economist at TD Economics notes, the new rules, which include reducing maximum amortization periods on insured mortgages from 30 to 25 years and cutting refinancing limits from 85 to 80 percent of the home’s value, will likely keep many marginal borrowers out of the housing market, and thus slow new home construction.


This should take some air out of a sector which has gotten frothy lately, particularly in some regional markets such as Toronto’s red hot condo segment. “The impact on real estate markets is roughly equivalent to a 1% increase in interest rates,” notes Alexander, who called these latest in a series of tightening initiatives as “a prudent decision to address the increasing risks from consumer debt growth.”


A strong real estate sector, but other part of the economy struggle

Carney and Flaherty have a unique problem to deal with in the Canadian economy, whose housing sector continues to hold up well, despite the recent financial crisis, and continued global uncertainty. For example many European countries are in recession, as the continent continues to struggle with the fallout effects of the Greek crisis, which has spread to other economies, notably Spain and Italy which have been paying significantly higher interest rates on their national debts.


On the other hand, the United States, Canada’s largest trading partner, has put a gun to its own head, in the form of uncertainty regarding the “fiscal cliff,” - a series of tax increases and spending cuts, that will be implemented if Congress cannot come up with a budget deal by yearend. As if that were not enough, China, long the major engine of global growth has hinted that things are not going as well as it had projected. The country recently cut its growth forecasts and announced both a central bank rate cut and a tightening in reserve requirements.


Yet in the midst of all of this Canada has kept its own economy chugging along at a sub-par, though positive growth pace. The country created 7,300 new jobs in June, and the unemployment rate fell slightly to an eminently respectable 7.2 percent. However a major pillar of that growth has been the housing sector, where starts have been running more than twice as fast as US levels on a per capita basis, and prices have remained stable. The problem is that if you take housing, which is running far above trend levels, out of the equation, the rest of the economy is not doing so great. 


A surgical operation

As a result, Flaherty’s targeted solution could be just what is needed right now to both keep the real estate sector in check, while leaving the rest of the economy a chance to grow says one expert. “Changes to the government’s mortgage insurance guidelines and OSFI’s housing-related lending guidelines should be more effective in dealing with these specific risks that the “blunt instrument” of rate hikes,” noted Michel Gregory, a senior economist at BMO Capital Markets in a recent note to clients. “There is no doubt that the risks to financial stability posed by housing and household debt dynamics were underpinning the Bank’s tightening bias.”


As Robert Hogue, of RBC notes, the changes will hit marginal borrowers hard. For example a buyer who takes out a $288,000 mortgage to buy a $322,000 bungalow, at a posted rate of 5.25 percent, the reduction in the amortization period from 30 years to 25 years would pay an extra $136 a month, or 8.6 percent more. While that may be a hard pill to swallow, and may keep that buyer out of the housing market, the government is ready to accept that as the price of maintaining the soundness of the financial sector.




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