The Bank of Canada today released its semi-annual Financial System Report. To the surprise of precisely no-one, the Bank identifies the overvalued housing market and sky-high personal indebtedness as key risks for the financial system, and by extension for the entire Canadian economy, going forward. Nevertheless, it continues to forecast a soft landing for the housing market.
Releasing the Report, Bank Governor Stephen Poloz was much more explicit than he has been in the past about the duration and extent of the overvaluation. He indicated that the Bank's models suggest that the market has been overvalued since 2007, by an average of about 10 percent. The models show that the current level of overvaluation may be as high as 30 percent. This is a rather more sobering conclusion than the one reached less than a month ago by the Government's own housing agency, CMHC -- see this earlier blog post.
If the market really is overvalued by as much as 30 percent, how realistic is it for the Bank to continue to predict a soft landing? As the Report notes, the number of Canadian households classified as "extremely indebted" (defined as debt equal to 250% or more of annual income -- wow!) has doubled since the turn of the century, and now accounts for 12 percent of all households. It also notes that young people are carrying much larger debts than previous generations did.
Given these factors, the Bank's cautious optimism is based on two factors: the limited likelihood of any rapid increase in borrowing costs, and the expectation that global economic recovery will spur growth in the Canadian economy, and thereby in household incomes. The precipitous decline in oil prices should help on both counts. The Bank is set to lower its inflation outlook to reflect the sharp fall in retail fuel prices, which will allow it to delay any move toward restoring interest rates to more historically normal levels. As for the growth outlook, the fall in the exchange rate for the Canadian dollar will help boost export growth, while lower fuel bills will put money into the hands of consumers, potentially supporting higher growth in retail spending.
One caveat here, though. Lower oil prices will be beneficial for the Canadian economy overall, but threaten to have a negative impact in the oil producing provinces, notably Alberta. (Today's price for Alberta crude of around $50/bbl* is reportedly right at breakeven level for many producers). Most of the analysis of housing market overvaluation has tended to focus on Toronto and Vancouver, but the Calgary market is in a similar position, and may become the most vulnerable if low oil prices persist.
Maybe it will all work out fine in the end, as the Bank hopes. However, it's hard to avoid the sense that the Bank is at the mercy of events, rather than in control of the situation. As Gov. Poloz admitted today, the Bank has known for more than half a decade that the housing market is overvalued, and he and his predecessor Mark Carney have been warning for almost as long that household debt is too high. And yet there's no evidence that the Bank has any strategy to remedy the situation, short of hoping for the deus ex machina of low oil prices to skate the economy onside. Still less does it have any room for maneuver in the not inconceivable event that things fail to pan out in the benign way that it's counting on. Fingers crossed, Gov. Poloz!
* Yes, this is well below the WTI benchmark, which is around $61/bbl at the time of writing. Alberta crude has been trading far below WTI for a long time, reflecting the lack of pipeline capacity to get the product to refineries or shipping terminals.
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