The Bank of Canada's decision to embark on a series of interest rate hikes is already throttling back on growth. Thanks to those hikes, we have a Canadian dollar that is at least a nickel above any realistic estimate of its fair value, and a pace of overall economic activity that is now falling at a surprising rate.
The central bank's decision to raise interest rates was based on Canada's initially strong rebound from the depths of the recession. Unfortunately, the nature of that recovery may have sown the seeds for trouble ahead.
By my calculations, every basis point of the Canadian economic recovery was the result of the boom in the housing sector. That goose is no longer laying any golden eggs. In fact, from recent peaks, single-family housing starts have plunged 32 per cent, residential building permits have sagged 17 per cent and home prices on average are down 6 per cent. In the absence of an export resurgence, which seems unlikely given the ongoing sluggishness in the U.S. economy, the downturn in housing is bound to keep the pace of domestic activity rather sluggish in coming quarters.
I estimate real GDP for this quarter will grow at a meagre 1.5 per cent annual rate. That is a huge deceleration from the peak pace of 5.8 per cent in the first quarter of this year when Canadians were patting ourselves on the back for our apparent ability to "decouple" from the listless U.S. economy.
Canada's economy is now slowing down at a more pronounced rate than is the case south of the border and the Bank of Canada's latest 2.8 per cent forecast for third quarter real GDP growth is looking stale, to put it charitably.
There is no doubting the fragility of the recovery, which suggests that the Bank of Canada should put further rate increases on hold for a while. But its recent decisions illustrate how difficult it is for a central bank to navigate the right path between stimulating the economy with low interest rates and cooling off irrational exuberance with higher rates.
Even though I was one of the "doves" advising the bank to refrain from raising rates earlier than planned, there was method in its madness. When the bank followed the U.S. Federal Reserve on the path towards microscopic policy rates in the opening months of 2009, it pledged to maintain such an unprecedented degree of stimulus "conditional" on a prolonged period of economic malaise.
The problem, especially for interest rate doves like me, is that instead of seeing a listless economic recovery in Canada, we saw a bounce back of massive proportions. In short order, Canadian employment has soared to record highs while the U.S. is still more than seven million jobs shy of its pre-recession peak.
Canada's dramatic recovery has been taken as evidence of the fundamental strength of the country's financial system - but the rebound was founded on a surge in credit growth and housing-related spending that must have the Bank of Canada feeling a bit uneasy.
Bank-wide mortgage lending has risen 10 per cent in the past year, compared with only a 4 per cent rise in wage and salary income. This is clearly not sustainable.
At the peak of our own mania last fall, home prices soared more than 20 per cent on a year-on-year basis and home sales skyrocketed 70 per cent. These data points all have a "U.S.A. circa 2005" feel to them.
The ratio of total household debt to income has surged to 146 per cent, right where the U.S. peaked at the height of its credit bubble. Anecdotal evidence suggests that the home ownership rate has risen to record levels of 70 per cent, also close to where the U.S. peaked out during the housing bubble.
At the peak of our own mania last fall, home prices soared more than 20 per cent on a year-on-year basis and home sales skyrocketed 70 per cent. These data points all have a "U.S.A. circa 2005" feel to them.
Just to be clear, the Bank of Canada wasn't alone in spurring this huge - and unanticipated - housing boom. Canada Mortgage and Housing Corp. (CMHC) relaxed underwriting criteria in ways that made housing tremendously more affordable for marginal borrowers. Those home buyers could get a mortgage with almost no money down at near-zero short-term interest rates.
People can argue endlessly about whether the Canadian housing market constitutes a bubble. The reality is that we will probably find out at some time in the next year, as all the speculative high-ratio loans come due at interest rates above where they stood at the time of origination, courtesy of the Bank of Canada's tightening cycle, which may or may not have fully run its course.
Even if this correction in housing is only a fraction as harsh as was the case south of the border, the economy, and the financial markets are likely in for a rude awakening in coming quarters as lower home prices cut into household wealth, confidence and spending plans.
At the same time, housing deflation and a rising tide of mortgage delinquencies will bite into CMHC reserves and, at the margin, undercut the quality of Canadian banks' seemingly pristine balance sheets, which hold $500-billion of residential real estate loans, equivalent to 30 per cent of total bank assets.
It may well be that Canada escaped a housing bubble and its inevitable aftershocks. But it is a close call. If it wasn't a bubble, it was at least a giant sud.
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Bubbles
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David Rosenberg