Over the past two years, inflation has been on the rise in Canada, along with many other economies across the world. Most recently, the level of inflation has reached new 30-year highs and the Central Bank has begun to respond with a gradual rise in interest rates to attempt to slow inflation and soften the blow of a potential recession.
Inflation is hardly desirable in the best of times, but our current spike in inflation comes after a year of record highs in another area: household debt. A large majority of all the debt owed by Canadians is held in mortgages and both inflation, as well as rising interest rates, are likely to increase the burden on Canadians servicing mortgage debts. Mass amounts of debt could put the Canadian economy in a vulnerable position.
In this article, we will look at the Canadian household debt levels and how they can affect Canada’s economic recovery after the pandemic.
Household debt is broadly defined as the cumulative amount of money that a single household owes for all its debts. This includes mortgage debt which makes up the largest share on average but can include things like student debt, car loans, personal loans, and more. Generally, household debt is measured in a few different ways depending on what context we use.
One common way to measure household debt is the household debt to income ratio. This measures the value of a household's total debt against its disposable income. In the fourth quarter of 2021, Statistics Canada reports that the household debt to income ratio rose to 186.2, meaning that for every dollar of household disposable income, Canadians owe $1.86 on average.
Another measure of household debt is the household debt service ratio, which measures a household's disposable income against the value of their obligated debt payments. Though Canadians, on average, owe more than their income, they aren't due to pay this debt all at once which is where the debt service ratio comes in. Essentially, it measures how capable Canadians are of servicing their debts. The current debt service ratio was around 13.8% in the fourth quarter of 2021.
Finally, there is the measure of debt to gross domestic product. This measures the sum of all Canadian household debt against the country's yearly GDP. This measure compares the size of the economy to the amount of debt. If the ratio increases, it means debt is growing faster than economic growth. This is useful to know as the previous measures are more indicative of individual households' financial condition, debt to GDP can tell us a bit about the national economy as a whole and is a key indicator for analysts examining the potential occurrence and outcomes of economic crises.
The current level of Canadian household debt to GDP is about 107.9%. This is down from a peak of 119% in 2020. While it has decreased, the level is still elevated quite high from what is considered a healthy level and is far above other western nations such as the U.S. (78.5%) and the U.K. (87.7%). Only a few countries currently report a higher household debt to GDP ratio including Australia (119%) and Switzerland (131%).
As the ratio between household debt and GDP increases, it can put a damper on consumption, thus stunting future long-term GDP growth or leading to an economic crisis. According to the international monetary fund, high debt levels can also increase the severity and duration of recession and housing busts.
Inflation in Canada is measured by using the consumer price index. This index measures the changing prices of a range of everyday expenses from housing to groceries, gas, and more. In the same period that inflation has been going up, so has household debt. What is the relationship then between inflation and Canada's household debt, if any?
Mortgages make up the largest single component of Canadian household debt and this portion of debt has only been growing in recent years. As prices increased, so did the amount of debt that Canadians were required to take on in order to buy homes.
At the same time, the rise of house prices was a large factor contributing to the increase in Canadian inflation. Rather than seeing household debt or inflation as being caused by one another, it’s more helpful to see them as indicators of a separate factor, that is, lowered interest rates and an increased money supply.
When the pandemic hit, the Bank of Canada lowered interest rates further than ever before in order to encourage the flow of money to continue and avoid a recession. The result was that mortgage lending became cheaper than ever, which allowed house prices to grow thanks to Canadians' increased debt capacity.
The intent was to prevent the economy from tanking, and the results in the short term were positive. Though mortgage debt grew, other debts like consumer credit actually decreased. However, the country is now left to deal with the effects of inflation and increased household debts which may prove even more damaging in the future.
The Bank of Canada is now beginning to raise its interest rates in order to slow the rate of inflation in the country. In the past, this has proven a successful tactic to lower inflation, but it must be done carefully to avoid economic shock.
Some Canadians are now put in a tough position. Over the last two years, the sales of homes exploded and Canadians took on mortgage loans in an incredibly low rate environment. At the time, these were serviceable, but as interest rates and mortgage rates begin to rise, more and more Canadians will feel the squeeze on their wallets, especially those who bought at the highest point.
People will be forced to make tough choices on spending in order to keep up with their higher payments. If the housing market shifts and home prices begin to stagnate or fall, selling out of their now too expensive mortgages may no longer be a way to escape their debts.
High mortgage debt and rising interest rates does not mean we are headed for an imminent collapse of default crisis, however, it does put the Canadian economy in a vulnerable position. If the Bank of Canada moves too fast on hiking rates or any other number of unexpected economic shocks occurs, an overleveraged society is going to be hit much harder and many more Canadians will be pushed over the edge.
At our current levels of debt to GDP, it’s likely that future growth will be made more difficult for some time and at least some Canadians will take a heavy hit from their debt choices. With smart decision-making and careful execution, we can yet make it down from this mountain without catastrophe.
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