John Rapley is a political economist at the University of Cambridge and the managing director of Seaford Macro.
When the Bank of Canada decided last month to hold off on further interest-rate rises, many breathed a sigh of relief. In Canada, as indeed in all G7 economies just now, expectations are growing that the worst of the inflation surge has passed.
Some have gone so far as to declare victory in the inflation debate for ”team transitory,” saying inflation was only ever going to be temporary. In fact, to judge from action in bond markets, investors are now betting that rate cuts will start as early as next year. Cue the blog posts that the Roaring Twenties are now back on track.
But the celebrations may be premature. Buried in the notes of last month’s BoC meeting was concern about the impact of Canada’s housing crisis on inflation. While the big increases in mortgage rates should have knocked prices down by now, the bank noted that “the ongoing structural shortage of housing supply in the economy was sustaining elevated house prices.” Owing to this, even though a majority of governors voted to hold rates constant, some favoured a further hike.
Because until Canada brings real estate prices down further, not only will the housing crisis endure, but the economy will probably continue to struggle with a stagflation problem, with prices rising in a weak economy.
The BoC is not the only central bank warning it’s too early to declare victory in the war on inflation. U.S. Federal Reserve governors have been making similar noises, while earlier this week, amid rallying bond markets, Bank of England Governor Andrew Bailey warned that it was “far too early to be thinking about rate cuts.” And scarcely anyone would say that housing prices in Canada are anything healthy for the wider economy.
It’s a bit puzzling that the macroeconomic effects of real estate prices have received so little attention until now. It stands to reason that if the prices of real estate rise, businesses will face pressure to raise costs to cover high rents, and workers will seek higher pay to be able to cover their increased living costs. Indeed, evidence from the U.S. suggests that over time, when the value of real estate has risen relative to other assets, inflation tends to follow. Equally, growth then slows, resulting in the sort of stagflation we have seen of late.
What lessons might Canada infer from the American experience of how to break free from this trap? Since the 2008 financial crisis, the Canadian and U.S. economies have gone onto different paths. Whereas Canada’s per capita GDP had previously tracked its southern neighbour, since 2008 it’s been falling behind.
It may just be that real estate explains the divergence. One significant impact of the 2008 crash was that the value of real estate relative to other assets stopped rising south of the border. Not so in Canada, where real estate took off. Even though many Canadians might not want to hear it, the key lesson from the U.S. may be that if you want to restore economic growth, you need to puncture the housing bubble – and puncture it big time.
Canadian house prices have now stopped rising and begun falling from their peak. But south of their border, real estate prices fell a fifth from their 2007 peak, and in real terms didn’t recover for more than a decade. Canada probably has a way to go yet, and the faith that real estate prices should resume rising soon is probably misplaced.
Moreover, there’s only so much the Bank of Canada can do about this, given the structural conditions underpinning real estate prices. The bank can choke off demand by raising mortgage costs. But it can’t do much to boost supply, which means prices could bounce back quickly if it lowers rates – as happened earlier this year when it paused its rate rises and real estate markets turned briefly upward again.
One of the unusual features of the real estate market is that it tolerates a much higher degree of anti-competitive behaviour than is allowed in other markets. Frequent though the complaints may be that Canada tolerates oligopolies in sectors such as banking, food retail or telecommunications, if a company tries to drive potential rivals out of business with predatory pricing or buyouts and shutdowns, it will likely feel some heat from regulators.
Not so for real estate owners. They can attend a planning meeting to block a new development that will knock down the value of their asset. When combined with zoning restrictions that limit new house supply, it’s understandable the federal Housing Minister would lament that house building is illegal.
Taking all this into consideration, it seems clear that investors looking for a break from high interest costs and the return of rising prices should probably brace themselves for more trouble.