Bank of Canada says economy can handle higher interest rates

High household debt and elevated housing prices have become bigger vulnerabilities in the past year, but the economy can still handle the rising interest rates needed to tame inflation, Bank of Canada governor Tiff Macklem said Thursday.

“We think the economy needs higher interest rates, and it can certainly handle higher interest rates,” he told a news conference in Ottawa discussing the central bank’s latest financial system review.

The review notes high debts and home prices have increased the downside risks to overall economic growth, as rising rates meant to counter inflation increase the chance of households having to divert consumption towards debt repayments.

However, Macklem emphasized the overall financial health of Canadian households, as the average net worth increased by about $230,000 during the pandemic, and the focus of the central bank on reducing inflation over concerns of how higher rates may affect the housing market.

“Our primary focus is getting inflation back to target. You know, monetary policy is not housing policy,” he said.

“The increases in housing prices we’ve seen have been unsustainably elevated and we are expecting to see some moderation in housing activity and frankly, that would be healthy.”

He said that while the housing market is an important part of the economy, and the bank is watching the dynamics closely, the bank needs to slow demand in the economy and bring it in line with supply.

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The bank has indicated, and Macklem repeated Thursday, that it may have to move its key interest rate to upwards of three per cent to bring inflation back on target. He said the bank may need to “move more quickly, may need to take a larger step” to avoid inflation becoming entrenched.

The Bank of Canada raised its key interest rate target by half a percentage point last week to 1.5 per cent, a move that prompted the big commercial banks to raise their prime rates.

The report Thursday noted that increasing rates will put strain on mortgage holders, especially those who bought into the housing market during the pandemic as an increasing number of households have stretched themselves financially to purchase a home.

To illustrate the risks, the central bank ran a hypothetical scenario where five-year variable- and fixed-rate mortgages taken out in 2020 and 2021 renewed at median rates of 4.4 per cent and 4.5 per cent, respectively, in 2025 and 2026.

In this scenario, households that took out a fixed-rate mortgage during that period would see a median increase in their monthly payment of $300 or 24 per cent, while high loan-to-income ratio borrowers with a fixed-rate loan would see a median increase of $490 or 26 per cent.

However, those with variable-rate mortgages would face even larger increases with a median increase of $720 or 44 per cent in their monthly payment at renewal. High loan-to-income ratio borrowers who opted for a variable-rate loan would see a median increase of $1,020 or 45 per cent in their monthly payment.

Higher mortgage servicing costs mean less money to spend elsewhere which could have a negative hit on the overall economy, the report noted. Looking ahead to the first quarter of 2024, the trends have increased the probability of negative growth to 15 per cent, up by five percentage points compared to what it would have been had debt levels not changed during the pandemic.

Rising rates also increase the risk of a correction in the real estate market, which would erode equity and the ability for households to respond.

The report notes that the recent run-up in home prices, which gained about 50 per cent in the first two years of the pandemic, has been fuelled in part by increased buying by investors and the overall expectation that prices would continue to rise, both of which could “amplify” the decline in prices as the market reverses.

The real estate market has already started to cool since the bank has started raising its key rate, but the central bank said it’s too early to tell if it’s the start of a deeper, lasting decline.

The financial review noted that Canada’s banking industry could weather a downturn in both the housing market and overall economy. A stress-test where the economy declines 5.8 per cent over six quarters showed that while it would lead to sizable decline on bank capital buffers, the banks would still be broadly resilient.

The Bank of Canada noted in its review that other vulnerabilities to the financial system include cyber threats given the interconnected nature of the financial system, a risk that has increased from Russian aggression related to its invasion of Ukraine.

It said Russia’s invasion of Ukraine has also further complicated the transition to a low-carbon economy and increased the risks of a repricing of assets exposed to climate change.

But the key challenge for the bank remains high inflation rates, which Macklem said the bank hopes to reduce without pushing the economy into a recession despite the increased complexity of the challenges.