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A new study by the C.D. Howe Institute argues that lower mortgage payments sends the wrong signal about inflation, since lower interest rates support higher house prices.

DARRYL DYCK/The Globe and Mail

Canada's inflation measure doesn't properly capture rising house prices and runs the risk of causing the central bank to leave interest rates too low for too long, the C.D. Howe Institute argues in a new report Wednesday.

The Consumer Price Index (CPI), which the Bank of Canada uses to track inflation, is relatively insensitive to housing price changes and did not fully capture the recent run-up, report says. That's largely because the index looks to capture the cost of home ownership more than it does the actual price of houses. So when interest rates decrease, making monthly mortgage payments cheaper, the housing component of CPI drops.

The study by C.D. Howe analyst Philippe Bergevin argues that lower mortgage payments sends the wrong signal about inflation, since lower interest rates support higher house prices.

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The central bank has been using the CPI as an inflation indicator since 1991, when the country adopted a monetary policy based on inflation targeting.

"Inflation is a sustained increase in aggregate price level – a situation sometimes described as 'too much money chasing too few goods,'" the report says. "To adequately capture these phenomena, a price index should rely on market prices that result from actual transactions for goods and services and exclude other factors such as the cost of borrowing."

Because the CPI index is largely insensitive to movements in house prices, the central bank is not compelled to react to important changes in house prices by tightening or loosening monetary conditions, the report argues.

"Drawing on the U.S. experience, many observers have argued in hindsight that the Federal Reserve's policy of keeping rates of interest low for a prolonged period contributed to an environment of easy access to credit, which helped to establish the conditions necessary to support the housing bubble of the 2000s and the ensuing housing bust," it says. "It is clear that the Fed's preferred inflation measure – whose owner occupied housing component is based on rental equivalence – was not reflective of the extent of the housing boom."

Loose monetary policy, it concludes, may foster the conditions for housing prices to rise sharply.

As a fix, it puts forward the idea of using a measure which captures changes in market prices, such as those that are now used in Australia and New Zealand, in addition to the current CPI.

"Keeping everything else constant, the use of the proposed indicator as the official inflation target would have made the loose monetary stance of the Bank of Canada over the past year or so a little more difficult to defend," the report says. "During this period the CPI hovered around three per cent and the proposed indicator would have indicated even higher inflation."

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But, interestingly, going forward, "given that the Bank of Canada sets its policy rate on a forward-looking basis, and that housing prices are expected by many to decline or at least level off in the medium to long term, the use of the proposed indicator would actually support the case for continuing to keep rates at historically low levels," the report says.

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