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Stephen Poloz might have himself a housing bubble after all. How well he deals with it may well define his tenure as Canada's central bank governor.

The Bank of Canada dropped a bombshell Wednesday in its twice-annual Financial System Review (FSR), saying that its new model for assessing housing valuations estimates that Canadian house prices are between 10 to 30 per cent overvalued. Now granted, that's a big range, but it's the strongest statement yet from the central bank of just how overstretched Canada's housing sector might be.

At the 30-per-cent top of the range – about the biggest estimate we've seen anywhere – this would constitute a serious housing bubble. (Consider that when last decade's massive U.S. bubble burst, the ultimate damage was a 35-per-cent decline before it found solid footing again.) Even if you took the midpoint, 20 per cent, that's a huge overhang. And as the Bank of Canada noted, the estimated overvaluation range is in line with what the same model shows for the early 1980s and early 1990s – both of which were followed by housing corrections in the 10-per-cent range and, notably, recessions.

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Economists at Canada's big banks were quick to play down the overvaluation estimate, noting that the Bank of Canada itself characterized the risk of a big housing correction as "low" and is still confident about a soft landing for the sector. But consider this: The central bank dedicated a special information box to the issue in the FSR. It issued a separate report on housing-market valuations in conjunction with the FSR. And Mr. Poloz specifically addressed the overvaluation estimate in his opening statement for the press conference that followed the FSR's release. The central bank isn't in the habit of talking about things, at length, that it doesn't consider important. It doesn't start new conversations unless it wants to put an issue on the public radar screen. This matters.

Indeed, it may be the one big economic hurdle Mr. Poloz still has to overcome if he is going to successfully steer Canada's economy back to something resembling normal – a state we haven't seen since before the 2008 financial crisis and recession. The overshoot of the housing market, and the related bloating of household debt, represent the albatross Canada still bears from its efforts to defend its economy from disaster in the depths of the global economic and financial crisis. The federal budget deficit has been eliminated, economic growth and exports and even jobs are coming back. But we needed ultra-low interest rates to breathe life into the economy – and the price is a hyperventilated housing market.

The problem is what happens when we start to shut off the ventilator. The Bank of Canada is probably only six months away from having to start seriously contemplating its first interest-rate increases since 2010, as the growing economy absorbs its excess capacity. In those 1980s and 1990s corrections, it was the arrival of rising interest rates that toppled the housing market from its lofty perch.

One thing the central bank is, well, banking on is that the current housing overshoot has come in the absence of an inflation problem. In both the early 1980s and the early 1990s, policy makers needed to jack up interest rates pretty quickly to fight a surge in inflation – to which a spike in housing prices was a significant contributor. By contrast, the bank has been adamant that inflation is no threat today, and housing prices haven't experienced a recent surge.

Still, the possible extent of the housing overshoot leaves Mr. Poloz with a pivotal policy dilemma. On the one hand, the longer the central bank keeps its policy rates low, the more gasoline it pours on an already roaring housing market.

On the other hand, the housing boom may have reached such proportions that pulling the interest-rate rug out from under it could destabilize it, and the economic consequences could be severe. Meanwhile, the economy creeps closer to the point where rate hikes would normally be prudent and warranted; wait too long and you have a whole new set of problems on your hands.

In trying to assess what route Mr. Poloz will take, probably the most important thing to remember is this: He has made it abundantly clear that he cares more about downside risks than upside, as they pose the bigger danger to Canada's economic well-being.

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The biggest risk to the housing overshoot would appear to be raising rates too high, too soon, and toppling the whole apple cart. The central bank's new housing analysis adds to the list of reasons the bank will err on the side of starting rate increases later, and raising them slower than might normally be warranted.

It will almost certainly be the most important call of Mr. Poloz's tenure. History will one day tell us if he got it right.

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