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A record mismatch between housing demand and supply is forcing economists to reconsider the role interest rates will play in cooling runaway house prices.

Typically, rising rates cool a hot housing market by making mortgages more expensive. During the current rate hike cycle, however, the supply of homes is so low relative to pent-up demand – in both Canada and the U.S. – that traditional economic models may not apply.

This dynamic caught the attention of some U.S. economists this week, who started cautioning that rate hikes probably won’t wield the power they normally do over the housing market.

In the U.S., mortgage rates have already jumped to 5 per cent, which is an 11-year high. “Standard economic models suggest that an increase of that magnitude should weigh substantially on housing, the most interest-rate-sensitive segment of the economy and the textbook channel of monetary policy transmission,” Ronnie Walker, a U.S. economist at Goldman Sachs, wrote in a note to clients.

“However, the extreme supply-demand imbalance in today’s housing market will likely dampen the hit to activity from higher rates,” he wrote. “Using state-level data, we show that existing home sales are only one-third as sensitive to changes in rates in a supply-constrained environment.”

Mr. Walker and his team also found that housing starts have historically been unresponsive to changes in mortgage rates when supply can’t keep up with demand. The likely reason: “Homebuilders are able to continue building with little fear that homes will sit vacant after completion.”

This dynamic is supported by fresh data on U.S. housing starts released Tuesday. Despite a major jump in mortgage costs since the start of the year, housing starts in March beat expectations, rising 0.3 per cent month-over-month instead of the estimated decline. “The market may have some room to run yet before the Fed’s tightening cycle becomes a binding constraint,” Shernette McLeod at TD Economics wrote in a note to clients.

It is still too early in the rate hike cycle to make any definitive claims. However, if housing demand remains robust, it “may suggest the Fed will have to hike rates more than expected,” Bill McBride, who pens the CalculatedRisk newsletter that specializes in housing, wrote this week.

In other words, if the effectiveness of each increase is diminished by the powerful demand-supply mismatch, an unusually high number of hikes may be needed to restore some order in the housing market.

The economists who wrote about the dynamic this week were focused on U.S. housing, but there are many parallels to Canada. For one, U.S. housing inventory is at a record low, and Canada is close to its own. Nationally, at the end of March, there were 1.8 months of inventory in Canada, only slightly higher than the record low of just 1.6 months in the previous three months, according to the Canadian Real Estate Association, or CREA. The long-term inventory average is more than five months.

House prices have also skyrocketed in both countries. In the U.S., they climbed 19 per cent in the past year, while in Canada, they are up 27 per cent nationally over the same time frame, according to CREA, though they barely budged in the last month.

It is possible the two housing markets will diverge, in part because of structural differences between them. The U.S., for one, relies on 30-year mortgages, while Canadian fixed mortgage rates reset every five years.

But even then, the Fed’s response to the U.S. housing market has an outsized influence on the Canadian economy overall. The vast majority of Canada’s exports are sold into the U.S., and any difference between the two countries’ interest rates can have a significant influence on the value of the Canadian dollar relative to the greenback.

Canadians, then, ought to pay attention to just how unusual the U.S. housing market is right now. Mr. Walker, the Goldman analyst, found that when housing vacancy rates are above 2 per cent, a percentage point increase in mortgage rates typically slows existing housing sales by 6.5 per cent. When the vacancy rate is below 1 per cent, sales only slow 2.5 per cent.

At the moment, the U.S. nationwide housing vacancy rate is 0.9 per cent, the lowest level since 1978 and equal to the lowest level in the measure’s 66-year history, according to Goldman Sachs.

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