The Bank of Canada's surprise move to cut interest rates reflects a tricky balancing act: Protect the economy from the oil slump, without fuelling household debt that's already near record levels.
In dropping the overnight lending rate to 0.75 per cent from 1 per cent, its first rate cut since September, 2010, the bank shocked markets by putting long-standing worries over rising levels of household debt behind a bigger concern: what plummeting oil prices will mean for the country's economy.
Only last month, Canada's central bank renewed its warnings about rising levels of household debt, which hovers near an all-time high of 163 per cent of disposable income, and said it believed home prices were as much as 30 per cent overvalued. Yet, in lowering rates, the bank made it clear it sees the effects of lower oil prices spreading far beyond the borders of Alberta, with job losses and cuts to income potentially cascading throughout the economy and leaving indebted households even more vulnerable.
"This decline in oil prices has been a shock to Canadian incomes, which from a debt-to-disposable income point of view is not good news," senior deputy governor Carolyn Wilkins told a press conference. "Certainly the interest rate movement we made today is designed to offset part of that."
In its monetary policy report, the bank predicted that without an interest rate a cut, the household debt ratio could have risen by as much as four percentage points as plunging energy profits harm investor portfolios and the job market.
Canadians who headed west in search of employment are returning east, making job markets more competitive in other provinces and contributing to a rise in unemployment and a drop in incomes.
"The record-high evolution of [debt to income] is something which matters a lot to us because it makes the economy vulnerable to a shock," Bank of Canada Governor Stephen Poloz said, adding the bank sees plunging oil prices as "exactly the kind of trigger we imagine."
Yet by slashing interest rates after years of warning about the risks that rising house prices and skyrocketing consumer debt levels pose to the economy, the bank also runs the risk that consumers will start turning a deaf ear to its long-standing pleas for Canadians to curb their appetite for cheap credit and may even fuel the flames of the country's overheated housing market.
"At the end of the day, if you're a consumer or a homeowner and you see what essentially now amounts to zero or slightly negative real interest rates, you're going to go out and borrow, probably no matter how much the bank is telling you not to," said Bank of Montreal senior economist Robert Kavcic.
A rate cut will be "unambiguously good" for the Canadian housing market, particularly outside Alberta, said Toronto-Dominion Bank economist Diana Petramala. Consumers seemed to echo that sentiment yesterday, with real estate brokerage Zoocasa reporting that traffic to its online listings website jumped 20 per cent after the bank's announcement.
A cut to the central bank's overnight lending rate will make it cheaper for the roughly 30 per cent of home buyers with short-term or variable-rate mortgages, said Bank of Nova Scotia economist Derek Holt.
Ms. Petramala expects mortgage rates to follow, with banks possibly reviving teaser rates below 3 per cent and said yesterday's rate cut has raised the likelihood the central bank could cut rates even further down the road. Five-year Government of Canada bond yields touched 0.8 per cent yesterday, down from 1.4 per cent at the start of the month.
While that will give a boost to already strong housing markets outside of Alberta, particularly in cities like Vancouver and Toronto, it also risks encouraging young home buyers to take on more mortgage debt than they can afford. "It's important for [buyers] to not forget that this is not a normal interest rate environment," she said.
An interest rate cut will only mean good news for Vancouver's housing market, said Hareesh Sara, president of Intergulf Development Group, which has several housing and condo developments under way in both British Columbia and Alberta. While his company is being cautious about whether to proceed with planned developments around Calgary and Edmonton, it is plowing ahead with projects in B.C.'s Lower Mainland, where sales had already been strong even before the surprise rate cut.
"I think this is going to be a huge boost because money is even that much cheaper," he said. "It will certainly help prices. People might be jumping in now because nobody expected this rate cut." The lower Canadian dollar will also likely make B.C. housing market more appealing to foreign investors, he added.
Several analysts, however, warned that while the rate cut may give a short-term boost to home buyers, it also heightens the risk of a more severe housing correction when interest rates eventually rise.
"If housing prices rise too much in the short-term, eventually they might need to correct more," said Royal Bank of Canada senior economist Robert Hoult. "If lower interest rates in the near-term cause home prices to increase more, I think it does raise some risk for down the road."