It is amusing to the see federal parties arguing over the position taken by Finance Minister Jim Flaherty, who scolded Manulife for reducing its five-year mortgage interest rate from 3.09 per cent to 2.89 per cent. Manulife retreated and upped the mortgage rate in deference to the Minister. Here we have a free-market populist Conservative government pushing a financial institution to raise a market-based interest rate while the NDP and Liberals criticize Mr. Flaherty’s move as retail interest rate regulation that undermines the rule of law and results in high bank profits. You would think we are living on another planet right now.
The crux of the issue is simple. The Bank of Canada has held interest rates to low levels for almost five years due to economic slack in the economy. Consumer core inflation rates are well contained for now, and plodding growth does not suggest that we are in for a bout of inflation any time soon. However, housing prices in the past few years have been rising, especially in the heated markets of Vancouver and Toronto. Both the governor of the Bank of Canada and the minister of finance are concerned about Canadians taking on too much household debt – which has risen to about 165 per cent of disposable income. Although Canadian household debt is only 20 per cent of household assets, the concern is that some have over-extended themselves by investing too much with cheap credit.
To take some heat of the housing market, the minister quite rightly tightened rules to make it more difficult for house owners to borrow. This has included shortening the borrowing term to 25 years, as well as limiting the access to taxpayer-guaranteed CMHC mortgage insurance provided to borrowers who purchase a house with a down payment that is less than one-fifth of the home’s value. These rules have had their impact: they have reduced the demand for mortgages and have cooled housing markets.
There is, however, another side to this. Less demand for mortgages relative to supply of funds puts pressure on financial institutions to lower mortgage interest rates. However, lower interest rates starts undoing the regulatory policies intended to curtail mortgage demand. This should not be surprising – we know from enough studies that the incidence of regulations and taxes is to cause prices to adjust.
BMO tried reducing interest rates, which earned the wrath of the finance minister. Now, Manulife received the same treatment. In the meantime, provincial financial institutions like credit unions are not limited in the same way and can compete with banks on more favourable terms.
It is targeted price control that is particularly problematic with Mr. Flaherty’s intervention. As the market is responding to excess supply, the government is pressing some financial institutions to keep interest rates high. It is not clear that this response is productive. If we are going to control interest rates in this way, why not use monetary policy to tighten up credit, which applies to the whole market?
The concern with a tighter monetary policy putting the brakes on our low-interest-rate environment is that it might prick the housing bubble but hurt the economy in other ways. So, if monetary policy is not the tool, then there should be tighter rules for mortgage credit. However, it is not at all clear this is required: If a sufficient down payment is now required to buy a home under the new rules, why worry so much about mortgage debt which is substantially below household assets at this time? If it’s not, then the minister should tighten rules more.
Of course, the opposition parties are happy to play politics. Accusing banks of high profits is particularly strange. Profits arise from the spread between lending and borrowing rates that has to cover labour and capital costs including the required return on capital to finance bank operations. Even if profits are too high (and it is not clear they are), it might not be a matter of adjusting mortgage interest rates – instead depositors might get a better yield on their deposits including GICs. If there is sufficient competition in markets, spreads will fall and bank profitability will reflect how much capital they need to deploy.
In the end, it might be good for both the government and opposition parties to step back and rethink their positions. A more reflective policy might clear the air.
Jack M. Mintz is Palmer Chair, School of Public Policy, at the University of Calgary.