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House price overvaluation fading: TDMoe Doiron/The Globe and Mail

TD Economics has gradually reduced its estimate of the overvaluation in Canada's house prices, as the growth in people's disposable income picks up while the market stagnates.

The quarterly economic forecast that the bank released Tuesday pegs the current overvaluation in the market at 10 per cent. It had previously estimated that prices were 15 per cent too high, and then suggested a range of 10 to 15 per cent.

The decrease is deliberate, says TD chief economist Craig Alexander.

The estimate of overvaluation looks at where house prices are, compared to where the underlying economic data – such as employment, incomes and interest rates – suggest they should be. Unemployment has been ticking down, personal disposable income growth has been picking up, and the growth in house prices has been slowing.

"We update the assessment of the degree of overvaluation as things evolve," Mr. Alexander says.

The estimate brings up an interesting point – one that Mr. Alexander suggests is important. There are two ways that the overvaluation can work itself out in the coming years, and one of those options is rarely discussed. The obvious path is for house prices to fall. The less-obvious path is for the economy to improve.

"Our ideal outcome for Canada would be one where prices are basically flat and the economy grows and incomes rise and the overvaluation disappears that way," Mr. Alexander says.

"Fingers crossed, I'd love it if our forecast for a pullback in prices was proven false and what we get is a flat price environment for three years. History isn't on our side on this, though, and I do think that when interest rates rise we will see a further pullback in prices."