Same song, different key

The Bank of Canada issued its 2022 Financial System review this morning. Governor Tiff Macklem and Senior Deputy Governor Carolyn Rogers met with the media to discuss the key findings, with a particular focus on what the Bank sees as the principal vulnerabilities in the Canadian financial system. 

Unsurprisingly the number one area of concern is, as it has been for many years now, the elevated level of house prices and the associated rise in household debt. Ultra low interest rates triggered by the COVID pandemic induced a large number of Canadians to take on substantial amounts of debt to acquire a home, which naturally drove up house prices, by as much as 50 percent.  Even the modest rate hikes implemented by the Bank so far this year have been sufficient to trigger an abrupt change from a seller's market to a buyer's market in many parts of the country, underscoring the Bank's concern. 

The Bank acknowledges the "remarkable" improvement in overall household savings and wealth during the pandemic, but then quickly moves on to emphasize the vulnerability of certain homeowners: 

....even as the average household is in better financial shape, more Canadians have stretched to buy a house during the pandemic. And these households are more exposed to higher interest rates and the potential for housing prices to decline.....Throughout the pandemic, a growing number of Canadians took out mortgages that were very large relative to their incomes, at variable rates with amortization periods of more than 25 years. And our models suggest that the most highly indebted households saw only a small increase in their liquid assets in that time.

The Bank acknowledges that vulnerability may at some point constrain its efforts to bring inflation back to the 2 percent target:

With inflation well above the 2% target and the Canadian economy overheating, the Bank’s number one priority is to get inflation back to target, and we are raising interest rates to make that happen....The economy can handle—indeed needs—higher interest rates.... If the economy slowed sharply and unemployment rose considerably, the combination of more highly indebted Canadians and high house prices could amplify the downturn....Were this to affect many households, it could have broad implications for the economy and financial system. This is not what we expect to happen. Our goal is for a soft economic landing with inflation coming back to the 2% target. But it is a vulnerability to watch closely and manage carefully.

In short, the Bank thinks it can engineer a soft landing as it brings inflation down, but it is by no means certain of that. 

The opening statement goes on to talk in much less detail about three other vulnerabilities. Two of these are predictable enough: the war in Ukraine, with its potential for cybersecurity threats, and the transition to a low-carbon economy, which may abruptly reprise financial and real assets. The third is a bit more novel:

Finally, cryptoassets are a growing vulnerability. More Canadians are investing in cryptocurrencies. But the growth of these markets has outpaced global efforts to regulate them. Like other speculative assets, cryptocurrencies are vulnerable to large and sudden price declines. And recently, some stablecoins—a type of cryptocurrency—have failed to deliver on their promise of stability. While cryptoassets do not yet pose a systemic risk to the Canadian financial system, the lack of regulation means they don’t have the safeguards that exist for more traditional assets. And their risks may not be well-understood by investors. Regulators around the world and in Canada have recognized this risk and are working to address it.

Given the collapse in crypto "asset" values in the last couple of months, this is a timely warning, especially as the statement that "their risks may not be well-understood by investors" is almost certainly a colossal understatement. 

All in all, then, plenty for the Bank of Canada to keep a wary eye on -- but as always, it is the housing market that seems to warrant the most concern.