In the past 50 years, there have only been two periods of monetary tightening by the Bank of Canada that did not trigger a recession, according to analyst firm Oxford Economics. The current upward phase in interest rates should not inflate this figure.
Hyun Song Shin, economic adviser and head of research at the Bank for International Settlements, counted 70 episodes of monetary austerity during the period 1980-2018 among 19 advanced economies and 6 emerging economies. The signals received remain confused. Typically, proactive central bank action and a shorter or moderate up cycle in the cost of money leads to a soft landing. However, the central banks reacted late in initiating the current phase of tightening. Moreover, the starting point characterized by strong GDP growth and a high level of vacancies generally gives the same outcome. The current phase has a similar starting point, but adds a series of indicators rather evoking a difficult landing called recession.
These days, soaring inflation isn’t just about excess demand. It is also fueled by the presence of a persistent and entrenched supply shock, amplified by the impact of Omicron and its sub-variants on the supply chain. Added to this are the economic repercussions of Vladimir Putin’s war against Ukraine in the form of rising energy and food prices. Not to mention the influence of a tight labor market. So lots of headwinds and exogenous variables to restore the balance between supply and demand.
The Bank of Canada must, in addition, steer with one of the most interest-sensitive economies in the G20. It must maneuver in a context of high household indebtedness and real estate exuberance in order to stem the rise in prices and avoid an unanchoring of long-term inflationary expectations likely to generate a wage-price spiral.
“Survey results indicate that more consumers and businesses expect inflation to be higher for longer, heightening the risk of high inflation entrenching pricing and wages. If that happens, the economic cost to restore price stability will be greater,” the Bank of Canada warned last week.
Lots of work ahead!
Real estate correction
The immediate aftermath of a Bank of Canada key rate going from 0.25% to 2.5% in less than 6 months — with more hikes in sight and a variable mortgage rate expected above 5% by the end of 2022 compared to an average of 1.3% at the end of 2021 — are measured in the residential real estate market. For Desjardins Group, the probability of a recession in 2023 now fluctuates around 50%, with residential investment expected to be the main brake on economic growth.
Under the influence of the explosion in the valuation of homes and the start of the normalization of monetary policy, since the spring of 2021, the Teranet-Bank index Nationhouse price ale is above household purchasing power, with the gap now reaching 46%.
With rising interest rates taking over, Oxford Economics sees further deterioration in affordability. Its specific index, which uses a benchmark compound price rather than an average price, widened further in the first quarter to hit 1.28 Canada-wide, up 12 points from the previous quarter. The typical home price is 28% above the median income’s borrowing capacity and remains out of reach for a typical household. Driven by rising rates, the index is expected to peak at 1.45 in the third quarter. Oxford now pegs the correction in Canadian residential real estate at 27% (peak to trough) by the first quarter of 2024 — the decline has already reached 11% since the peak in February — and sees no return in the affordability zone (0.9-1.1) before 2026. But hey.
In Quebec, the accessibility index rose from 7 points to 1 in the first quarter, while there was a deterioration of 8 points in Montreal and 5 points in Quebec. At 1.09, the Montreal index should reach 1.25 towards the end of the year. It would drop to 1.5 in Ottawa-Gatineau, up from 1.37 in the first quarter. At 0.67 in Quebec against 0.58.
In a text published on July 11, two days before the surprise announcement of a 100-point increase in the Bank of Canada’s target rate to 2.5%, the chief economist of the Canada Mortgage Corporation and housing analyst Bob Dugan sketched out a moderate rate hike scenario, with the key rate hitting 2.5% by early 2023. And another forecasting a steeper hike, to 3.5% in early 2023 Economic growth would bottom out between the fourth quarter of 2022 and the first quarter of 2023. It would be slightly negative during these two quarters, which would signal a weak recession, he believes.