Stability now?

This morning the Bank of Canada released its Financial System Review, a semi-annual report in which Bank sets out and analyzes what it sees as the key risks to the stability of the domestic financial system.  By way of an appetizer, yesterday had seen releases on related topics from two respected sources.  First, the OECD warned of the growing risks posed by the soaring housing market, and urged governments to do more to bring prices back to more sustainable levels.  Then, the government's own Financial Consumer Agency of Canada warned of the soaring use of home equity lines of credit by a rising number of Canadian households,  Use of these so-called HELOCs has contributed in no small way to the rise in household indebtedness to all-time record levels.

The Bank's own Review begins by noting that the two key vulnerabilities of the domestic financial system -- household debt and imbalances in the housing market itself -- have both worsened in the last six months. The quality of government-insured mortgage debt is improving, in the wake of tighter rules imposed last year.  However, uninsured mortgages are growing more rapidly, and there are indications that the credit quality of some of these mortgages is deteriorating.

The Review assesses two ways in which high house prices and high household debt could turn problematic:

• an externally-driven recession, in which the housing market would be but one of the ways in which the economy takes a hit.  Rising unemployment would put household finances under pressure, potentially affecting the stability of the financial system.  The Bank warns that the impact of such an external shock could be severe, but it judges that the likelihood of such an event is low, given improving global growth prospects.  This optimistic view of the macro outlook is largely in line with the aforementioned OECD report, which sees global GDP growth of 3.7 percent this year and slightly higher in 2018.

• a sudden correction in house prices, particularly in the Toronto and Vancouver areas.  The Bank sees this as a more probable event than a recession, but believes that the impact on the overall economy and on the financial system would be significantly smaller.  Given the rapid response of Toronto-area house prices to the measures taken by the Ontario government in April to cool the market, the risk of a sharp and uncontrolled correction may in fact already have diminished to some extent. 

There are two key takeaways here.  The first, explicitly stated by the Bank, is that "the financial system remains resilient", which is obviously good news.  The second, not explicitly stated, is this: if the Bank sees a recession as a more severe risk, albeit less probable,  than a housing market correction, it will obviously continue to set monetary policy mainly with an eye to keeping the economy growing.  A number of commentators have begun to suggest that rate hikes are starting to loom larger in the Bank's thinking; the Financial System Review suggests this is not yet the case.