Spelling out the risks

In many ways the Bank of Canada's Financial System Review contains little that we haven't heard before. Household debt is too high, which could pose problems if interest rates start to rise or the economy stalls again. The fall in oil prices makes it hard to assess the near-term outlook for the economy. And as always, developments on the international front could have negative implications for Canada -- though somewhat surprisingly, the Bank seems to be more concerned about China than about Greece.

Interestingly, though, the Report allows us to see in clearer-than-usual terms the balancing act that the Bank is trying to perform as it sets policy.  The Report reiterates the Bank's view that Canadian housing prices may be overvalued by as much as 30 percent, primarily reflecting stratospheric price levels in Toronto and (especially) Vancouver. Household debt, much of it taken on in order to participate in the housing market, is close to all-time record levels in relation to household income, at 163.3 percent. The ratio fell marginally in April, but still poses a huge risk to the economy and the financial system.

These interrelated facts -- the surging housing market and excessive household debts -- are the direct result of the Bank of Canada's very accommodative monetary policy over the past half decade. Yet there is no sign that the Bank is anywhere close to changing course, as the growth outlook remains below par and inflation slips below the 2 percent target. Indeed, the Bank unexpectedly added further monetary stimulus by cutting rates back in January, and there is a growing opinion among Bay Street analysts that there may be one or even two further cuts this year.

This, then, is the Bank of Canada's balancing act -- or gamble, as it might be better to portray it.  It knows that at some stage there will have to be a correction in the housing market.  However,  it judges that it can't afford to raise rates -- an action that would almost certainly trigger such a correction -- because that might slow the economy so much that household debt levels would become unsustainable, which would turn the correction into a rout.  In effect, this is a gamble that the economy will grow quickly enough to start reducing the debt-to-income burden, but not so quickly that inflation starts to rise and forces the Bank's hand.

It's far from clear that this is a good bet, and it's even less clear that the Bank was right to double down with its January rate cut. Despite recent encouraging employment data, the so-called rebalancing of the economy away from dependence on oil is proceeding at a snail's pace. As I've noted here many times before, much of the manufacturing capacity that might have been expected to benefit from the lower exchange rate is gone forever. In any case, prospects for that sector depend much more on what happens in the US economy, the destination for more than 70 percent of Canada's exports, than on any stimulus the Bank can provide.

That being the case, the January rate cut, and any further cuts that the Bank may see fit to make, can arguably have very little impact on the economy, yet may add considerably to the risks in the system, by encouraging Canadians to take on more debt and push house prices even higher. It's a dubious short-term gain set against the possibility of a serious long-term pain. If the whole house of cards toppled over, for whatever reason,  it would quickly bring about a crisis for the financial system that would almost certainly tip the economy back into a full-blown recession.

There's one further factor here that doesn't seem to get much attention in the Financial System Report: fiscal policy.  For the past several years, Governor Stephen Poloz, and his predecessor Mark Carney, were faced with a Federal government pursuing an economically asinine policy of fiscal austerity. Arguably, the governors had to keep monetary policy loose in order to stop the economy going off the rails altogether.

In recent months, however, the fiscal picture has changed. With an election coming in October, the Tories have been splashing the cash all over the place, with promises of more to come if (heaven forbid) they win re-election. If fiscal policy is no longer restrictive, it stands to reason that the need for massive monetary stimulus is diminished. At this juncture, however, there's no clear sign that the Bank is taking the new fiscal reality into consideration in making its monetary policy decisions. That may all have to change once the outcome of the election is known, especially if the more left-leaning NDP comes to power.

Interestingly, in doing some research for this post, I found at least one commentator who seems equally worried that the Bank of Canada is not worried enough.  Nice photo, though!