As economists continue to analyze the U.S. housing crash, a couple of U.S. writers turned their gaze upon Canada last week, with Matthew Yglesias wondering what should be done about rising housing prices and Dean Baker proposing a solution. Their concern is understandable, since just before the U.S. housing bubble burst the U.S. S&P Case-Shiller Composite-20 Index of housing prices had doubled from its Dec. 31, 1999 value. A Canadian equivalent, the Teranet-National Bank Composite House Price Index has more than doubled since 1999, causing speculation that Canadians are in store for a rapid decline in home prices. Not every headlong appreciation in housing prices indicates an unstable bubble, but there are reasons to be concerned.
A forthcoming research report by the Bank of Canada attempts to determine why real (inflation adjusted) housing prices have risen 45 percentage points between late 2001 and summer 2010. Much of the increase can be explained by fundamentals: up to 15 of the 45 percentage point increase can be explained by a rising population and up to another 11 can be explained by rising real incomes. Lower interest rates explain only six of the 45 points and the remainder includes a number of factors, including the belief that real estate prices will continue to appreciate.
While low interest rates are often seen as causing real estate bubbles, the academic evidence on this point is quite weak. The Bank of Canada findings are consistent with a Harvard Kennedy School policy brief that found the "data do not reveal a particularly strong relationship between interest rates and house prices. Real rates do impact prices…but the estimated impacts are not nearly big enough to explain the bulk of the variation in house prices." The Kennedy piece examines low real rates, not low nominal rates, but both have been at historic postwar lows over the past few years.
Although low interest rates by themselves are unlikely to cause real estate bubbles, six points out of 45 is not insignificant. This, coupled with the belief that real estate prices will continue to rise, should give some concern that real estate in some Canadian markets may be overvalued. A bigger concern is that price-to-rent ratios are above historical norms and indicate that real-estate is "overvalued by as much as 10 per cent."
The price-to-rent ratio is an imperfect indicator as there are reasons it can deviate from historical norms that do not indicate the presence of a housing bubble. But given the preponderance of evidence that house prices are overvalued, the new mortgage policies being put in place by Jim Flaherty -- and that nominal interest rates will eventually rise -- I predict that real estate prices will stay flat or decline slightly. A U.S. style crash appears unlikely, so dramatic solutions such as Mr. Baker's idea that the Bank of Canada immediately hike interest rates are likely to do more harm than good.
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