Canada could be at risk of a recession induced by a rapidly correcting housing market if the Bank of Canada gets too aggressive with its rate hikes, according to a report from an economist at Capital Economics.
In a Tuesday update, senior Canada economist Stephen Brown noted the central bank seemed unfazed by a double-digit drop in home sales in May — the second consecutive such monthly drop — and that it was adopting an increasingly hawkish tone on inflation.
“This raises the chance of the bank enacting a larger interest rate hike at its meeting in July and leaves us concerned that it will take a more aggressive approach to policy tightening than is ultimately required, driving house prices sharply lower and risking a major recession,” he said.
National home sales fell 12 per cent on a month-over-month basis in May, following a 14 per cent drop in April. While Brown suggested the declines would bring sales closer in-line to the pre-pandemic norm, the balancing of supply and demand gave him more reason for concern.
Furthermore, data from the firm found that the falling sales-to-new listings ratio in major markets such as Toronto, Montreal, Vancouver and Calgary implies home price inflation could drop from 18 per cent in April to zero by the end of the year.
Home prices are already dropping, according to Capital Economics data, sliding 0.6 per cent month over month across the country. Toronto saw its prices fall even faster by over three per cent for the second month in a row in May.
Brown noted Canada’s housing sector took up little space in the bank’s policy statement accompanying its decision to raise interest rates by 50 basis points on June 1, saying only that “housing market activity is moderating from exceptionally high levels.”
The bank will be delivering its 2022 Financial System Review on June 9, where it may go into more details about the moderating housing market.
As inflation runs at multi-decade highs — the Canadian price index surged 6.8 per cent in April — the bank has signalled it was ready get tough on rising consumer prices with stronger rate hikes. Bank of Canada governor Tiff Macklem suggested in April that the central bank could temporarily move the overnight rate above the neutral range of two to three per cent, which would neither help nor hinder economic growth.
Deputy Governor Paul Beaudry echoed this sentiment in a June 2 speech a day after the latest policy rate decision, saying the bank would need to lift its benchmark interest rate to at least three per cent to tame inflation.
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However, Brown argued the danger is the bank will misjudge the impact of its aggressive policy tightening and potentially send home sales into a tailspin.
“If the bank raised its policy rate to 3.5 per cent … then the housing market would face the most dramatic hit to affordability since the early 1980s Volcker Shock,” Brown said, referring to the period when Federal Reserve Chair Paul Volcker aggressively raised rates.
Brown added that by his firm’s estimates, a policy rate of 3.5 per cent would bring the average five-year fixed rate mortgage rate up to 4.5 per cent and the average variable rate to 4.9 per cent. Despite the accelerated wage growth this year, Capital Economics estimates these mortgage rates would reduce the maximum home price buyers could afford by 23 per cent, which Brown estimates to have four timez as large an impact as the prior three tightening cycles.