Careful what you wish for: rate hikes aren’t the answer

by Neil Sharma on 02 Jun 2021

A joint Nanos and Bloomberg poll last month revealed Canadians would welcome interest rate hikes as a means of cooling the housing market, but the reality is far more complicated than that.

“Who in their right mind would want interest rates to rise? Anyone who’s thinking they want interest rates to rise to slow home prices doesn’t understand how mortgage approval rules work because all mortgage approvals were written to 4.79%, now 5.25%, so what the actual interest rates are don’t actually mean anything as far as home prices have gone, because nobody is qualifying for any extra money over and above what they would if the actual interest rates were 4.79%, and 5.25% (as of June 1),” said Dustan Woodhouse, president of Mortgage Architects.

According to the poll, 49% of survey respondents either “support” or “somewhat support” the Bank of Canada increasing interest rates because they think it would quell runaway housing prices. But the reality is that it would take a significant rate hike to soften activity in the housing market, which would concurrently torpedo the economy, says Woodhouse, and as importantly, it would reduce homebuyers’ purchasing power.

“So to have a material slowdown in the amount of money people can purchase a home with, you would need interest rates to rise to 7.5-8.5%. That’s the real math on that,” said Woodhouse. “(Housing prices) would more than slow down: the entire economy would grind to a halt. The whole country would shut down. That would be like trying to kill a mosquito with a nuclear bomb.”

Woodhouse believes there’s a fundamental misunderstanding of how interest rate policy works, and according to Dr. Sherry Cooper, chief economist of Dominion Lending Centres, the largest mortgage network in Canada, the survey results elucidate yet more confusion.

“The housing market is not the Bank of Canada’s objective function; it is only supposed to be concerned about inflation,” said Dr. Cooper. “The problem is that interest rate policy is a blunt instrument and it leads to all sorts of unintended consequences. If you were to raise rates too much, you’d dampen the whole economy, which makes no sense given all the problems we still have in terms of jobs and getting the economy restarted. The Bank of Canada will never do it for that reason. It will raise rates when it thinks the economy is growing rapidly and is close to full employment.”

Interest rates are slated to rise in 2022, one year ahead of the Bank of Canada’s initial prognostication, because the economy appears healthier than anyone thought it would be at this stage of the pandemic. The Bank of Canada recently announced modest tapering of quantitative easing, signifying that it anticipates a return to full capacity sooner than expected.

“But all other things remaining constant,” Dr. Cooper said of interest rates rising quickly, “it would reduce buying power. The question is would it lead to a decline in home prices? It would take quite a tightening in monetary policy for that to happen, and tightening is unlikely.

“Even the housing market isn’t one market nationwide; it’s many, many different markets, so we could see home prices reverse in one area or one sector without seeing it happen in another. To see the overall average home price decline, which means it would have to be a widespread phenomenon outside of both Toronto and Vancouver, it’s not that it can’t happen but it’s unlikely.”

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