The Bank of Canada appears to have found a policy mix that it can live with.
We tend to forget, but Governor Stephen Poloz, cares almost as much about avoiding a financial crisis as he does about keeping inflation around two per cent, as per the marching orders from the finance minister.
The bankruptcy of Lehman Brothers Holdings Inc. and other cataclysmic events of 2008 showed there is no surer way to miss your inflation target than allowing a credit bubble to blowup on your watch.
That was the U.S. Federal Reserve’s miss, but central banks around the world realized the same could happen to them. The Bank of Canada responded by putting extra emphasis on its analysis of the financial system, doing what it can to shine bright lights on weak spots that could lead to collapse if the wrong shock came along.
In recent years, that’s meant sounding an alarm about record levels of household debt and bubbly housing markets in Vancouver and Toronto. Poloz, more than anyone, has tried to focus minds in Ottawa and on Bay Street on the financial system’s exposure to a cyberattack, observing in 2017 that too little was known about the country’s readiness to repel hackers. A growing pile of junk bonds has been another constant concern.
So the Bank of Canada’s assessments of the financial system have made for disconcerting reading. But things appear to be getting marginally better. For the first time in years, some of those vulnerabilities are starting to look less vulnerable.
The Bank of Canada’s annual Financial System Review (FSR) says household debt still is too high, but credit growth now is slowing and fewer high-risk borrowers are taking on more debt than they can reasonably afford. Similarly, sharp drops in home prices in Vancouver and Toronto since they peaked in 2016 suggest speculators have been chased from those markets, allowing the fundamentals of supply and demand to reassert themselves.
“The main vulnerabilities that we see today are the same as those in the 2018 FSR — elevated levels of household debt and imbalances in housing markets,” Poloz said at a press conference in Ottawa.
All things being equal, if the threat of a credit bust is receding, the central bank can focus on ensuring Canada’s faltering economy generates enough growth to keep inflation on target. That likely means leaving policy — both interest rates and “macroprudential” restrictions on mortgage lending — exactly where it is. The FSR credits various regulatory measures, including mandatory stress tests of mortgage borrowers and restrictions on international buyers in British Columbia and Ontario, for stabilizing financial conditions.
“Primarily, it’s the macroprudential framework which is keeping the financial stability risks in a zone of acceptability,” Poloz said. “That extra tool in the system gives us the ability to treat them as our secondary [concern], and not as our primary.”
The central bank also seems content with its interest rate setting after an abortive attempt to get borrowing costs back to a more normal setting.
Policy makers last year tested households’ capacity for higher borrowing costs — and then quickly pulled back as soon as data showed they had reached their limits.
They raised their benchmark interest rate a quarter point to 1.75 per cent in October and expectations were high for a few more over the months ahead. But weaker consumer spending and a sharp drop in home sales, combined with the big drop in oil prices, forced the central bank to the sidelines in December. They have since lowered their economic outlook, and now almost no forecaster expects an interest-rate increase before 2020.
The shift in expectations has dropped mortgage rates by about half a percentage point this year. That should ease worries about what would happen as thousands of post-crisis, five-year mortgages came up for renewal this year. National Bank estimates that about 17 per cent of all home loans were scheduled for renewal in 2019. In January, economists at the Montreal-based lender said those borrowers were facing a interest-rate shock of between 70 and 90 basis points. Not anymore. The rate on an insured five-year mortgage is about three per cent, about the same as 2014.
“Canadian households are currently benefiting from a stellar jobs market, rising disposable income, and falling mortgage rates,” Matthieu Arseneau said in a note to clients on Tuesday. “As a result, the potential payment shock for homeowners set to renew their mortgage this year has almost vanished.”
The FSR shows the Bank of Canada has come to a similar conclusion. The report says the biggest threat to financial stability is a “severe recession,” a low probability event given the central bank’s current forecast of a rebound over the second half the year. And the threat posed by a house-price correction is now classified as “moderate and decreasing.”
Poloz said the latest housing data, which include a 3.6-per-cent jump in existing home sales in April from March, suggest “we probably are right” that the sharp drop in real-estate spending over the winter was temporary and exaggerated by price corrections in Vancouver and Toronto.
Bottom line: Things are moving in the right direction. So the central bank has every reason to leave policy alone — for now. The decision to stop raising interest rates and the subsequent drop in the cost of credit represents a new temptation to over-borrow. That will test the current policy mix.
“I expect credit growth to pick up,” Poloz said. “As long as it remains in line with nominal income growth, our sustainability measures and risk measures will stay where they are … But it’s something we watch to make sure [borrowing] does’t take off again and start adding to those vulnerabilities like it was before.”
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