Why raise policy rates to control household debt when a surgical tool like macroprudential policy is available, and has already shown to have had an impact on the housing market the equivalent of a 200-basis-point hike in the overnight rate?
Bank of Canada Governor Mark Carney heightened the rate-hike watch this week by saying higher policy rates may be warranted if household debt metrics do not continue to correct to more normal levels “in a timely way.” The decision to raise rates, however, is not quite so straightforward. Rather, the Bank’s decision schematic is more like the standard computer programming logic: IF, THEN, ELSE.
How the Bank of Canada reacts will depend on the overall state of the economy. IF debt-to-income is rising alongside accelerating GDP, rising employment and rising asset values, THEN it makes sense for the Bank to hike because the combination of accelerating growth and rising asset values would soon absorb spare capacity and exert upward pressure on inflation. However, IF the ratio is rising because unemployment is rising and/or income growth is stalling, THEN the Bank would not hike.
That’s pretty obvious. It is the ELSE part of the formula – macroprudential policy – where it gets more interesting. Macroprudential policy is defined by the Bank of International Settlements as “policies that use prudential tools to limit systemic or system-wide financial risk.” Since the financial crisis, macroprudential policies have been used several times by Canadian policy makers, to great effect, to reduce the risks to the financial system created by the surge in housing prices and resale activity.
For example, the last tightening in mortgage lending standards announced by Finance Minister Jim Flaherty, which took effect in July, 2012, shortened the maximum amortization period for a mortgage from 30 years to 25 years. Translating this into the impact on the typical monthly mortgage payment is telling.
The shortening of the amortization period was the equivalent of a 100-basis-point rise in the effective five-year mortgage rate. Under normal reactions of longer-term interest rates to a higher overnight rate, the Bank would have needed to hike rates by at least 200 basis points to achieve the same result.
The reason to opt for macroprudential tools rather than hiking the overnight rate is the relative precision of the former relative to the blunt tool of monetary policy. And the results of the July, 2012, mortgage rule changes speak for themselves.
Home resales were down 15.3 per cent in March compared to a year ago, according to the Canadian Real Estate Association. Housing starts are down 27 per cent from the nearby peak in April, 2012, and are now in line with the rate of household formation at 184,000 annualized units as of March, 2013. Home price appreciation is now barely keeping up with the pace of overall inflation, with the March Teranet print at 2.6 per cent compared to last year and the slowest yearly pace since 2009.
Moreover, given the attraction Canadian government bond markets currently hold for international investors, opting for macroprudential tools over hiking rates could be the least disruptive choice for the financial system and the overall economy. As one of the dwindling few countries boasting a triple-A credit rating, foreign investors already own almost 30 per cent of Government of Canada debt, which is double the historic norm, having risen from barely 12 per cent in just the past five years.
These added foreign purchases keep Candian borrowing rates considerably lower than otherwise. As well, the capital inflows also serve to keep undue upward pressure on the Canadian dollar and undermine business international competitiveness. The merest whiff of an impending hike by the Bank of Canada could prompt even more foreign investors to flood into the Canadian fixed income markets.
Sheryl King is an independent macroeconomic strategist with more than 20 years experience in the international financial industry and central banking.