How far do housing prices need to fall before the Bank of Canada stops raising interest rates?

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How far will home prices have to fall before the Bank of Canada eases off on its rate-hiking strategy?

Further than you probably think.

The smart bet, until recently, was that the central bank would stop hiking rates at a level that might correspond to, say, a 10-per-cent decline in home prices. A fall of that magnitude would reverse several months of recent market gains. It would not, however, be a devastating blow to most long-standing homeowners or to the economy as a whole.

That benign outlook is fading. Central banks around the world, including the Bank of Canada, sound increasingly determined to crush inflation, whatever the cost. The recent rhetoric from policy makers in this country suggests that house prices – and the broader economy – could become collateral damage in the battle against persistently rising prices.

“The risk is that the bank will take a more aggressive approach to policy tightening than is ultimately required, driving home prices sharply lower and risking a major recession,” Stephen Brown, senior Canada economist at Capital Economics, said in an interview.

In a report this week entitled “Bank risks sending housing into a tailspin,” Mr. Brown outlined some disturbing numbers. He noted that recent rate hikes have already sent the national real estate market into a deep freeze. Home sales plunged in April and again in May.

Yet the Bank of Canada appears unconcerned. It devoted one sentence to housing in a policy statement last week. That was followed by a speech from deputy governor Paul Beaudry that didn’t even mention the housing market.

Instead, Mr. Beaudry took the opportunity to declare the central bank’s willingness to take “the policy rate to the top end or above the neutral range to bring supply and demand into balance.” Translated from the jargon, his declaration suggests much higher borrowing costs for homebuyers.

The bank considers its neutral rate – that is, the policy interest rate that would keep inflation pinned to the bank’s target when the economy is operating at full potential – to be between 2 and 3 per cent. If the bank were to follow through on its rhetoric and eventually take its policy interest rate, now at 1.5 per cent, to above neutral – say, to 3.5 per cent – the results would be dramatic. Five-year fixed mortgage rates would probably jump to around 4.5 per cent and variable rates to around 4.9 per cent, Mr. Brown estimates.

Both would constitute massive increases from the lows in September, 2021. Mr. Brown calculates that a median-income household devoting a third of its pretax income to mortgage payments at those higher rates would be able to afford a house worth only $525,000. Yet the average house price at the end of the first quarter was $875,000.

Even allowing for wage gains, “an average of those mortgage rates would reduce the maximum house price that a buyer could afford by 23 per cent,” Mr. Brown wrote.

This would constitute the most dramatic hit to affordability since the early 1980s. Back then, former U.S. Federal Reserve chair Paul Volcker took the lead in hiking interest rates to punishing levels. His take-no-prisoners attitude toward inflation was emulated by the Bank of Canada and other central banks and led to a brutal recession.

Could a similar scenario play out again? Mr. Brown thinks the odds are against it. Until recently, he saw the bank topping out its rate-hike cycle at 2.5 per cent. He now acknowledges that 3 per cent seems like a distinct possibility, but struggles to see policy makers going beyond that level because of the dire economic consequences.

The key, though, is what central bankers deem to be the greater danger – a potential recession or the risk that inflation could become embedded in the economy.

If the past year has taught us anything, it is that central bankers are struggling to stay ahead of inflation. In both Canada and the U.S., prices are rising at their fastest clip in decades. The latest readings, on Friday, showed U.S. consumer price inflation rose yet again in May, to an annualized pace of 8.6 per cent, while Canadian wages took an unexpected leap higher.

Markets have so far taken such flashing red lights with surprising equanimity. Look, for instance, at break-even rates, which measure inflation expectations in the bond market by calculating the difference between what inflation-protected bonds are paying and what conventional bonds are yielding.

These break-even rates have bobbed up only slightly. They suggest U.S. inflation will average about 2.8 per cent over the next decade – slightly higher than the 2 per cent preferred by central bankers, but no great reason to worry.

There are at least a couple of ways to interpret this odd lack of alarm.

One is that investors are confident inflation will fade of its own accord over the coming year as pandemic excesses dissipate.

Another is that investors are confident that central banks will do whatever is necessary to put a lid on inflation, even if it means hammering their economies with one rate hike after another.

Mr. Brown leans toward the former interpretation. He sees encouraging signs, such as the recent tumble in lumber prices, which suggest inflation could fade quickly as the economy gets over its reopening stresses. He worries that the Bank of Canada could be on the verge of a policy error if it turns unnecessarily hawkish on inflation just as price pressures are beginning to ease.

The bank itself, though, is talking tough. In its Financial System Review this week, it finally turned its spotlight on the housing market and didn’t pull its punches. It warned that mortgage payments five years from now could be 30 per cent higher than they are now because of rising interest rates.

The bank seems to be signalling that it won’t be deterred by the prospect of pain among homeowners. Anyone in the market for a home should pay attention. So should anyone looking at what the future holds for the Canadian economy.

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