Bank of Canada: Rate hikes could exacerbate financial system vulnerabilities

By Paul Vieira

OTTAWA – The Bank of Canada said Thursday that aggressive rate hikes needed to stifle historically high inflation could exacerbate existing vulnerabilities in the country’s financial system, highlighted by a growing number of households who are financially strained after buying of a house.

The central bank said it is unclear whether the recent decline in Canadian home sales and prices following rate hikes will be a temporary development or the start of a substantial and lasting price correction. Home prices in Canada have accelerated at a rapid pace during the pandemic, by around 50%, leading nearly every country in the developed world. Some economists are warning that the Bank of Canada’s determination to bring inflation down could push the housing market – a key driver of Canadian economic growth – into a serious tumble.

The central bank’s observation was contained in its annual review of the financial system, which aims to identify key vulnerabilities and risks in the Canadian financial system. The Bank of Canada defines vulnerabilities as pre-existing conditions that, if worsened, lead to a financial shock or crisis. The analysis is not intended to be a prediction of what the central bank expects to happen.

A rise in interest rates in Canada and around the world “could expose existing financial vulnerabilities,” the central bank said in the review. “Higher interest rates will increase the vulnerability of highly indebted households.”

The Bank of Canada raised its key rate last week by half a percentage point to 1.50% and signaled that it was ready to consider rate hikes above half a point to control inflation. . A senior official later added that the central bank felt the policy rate might need to rise to 3% or more to anchor inflation expectations at 2%. The Bank of Canada sets monetary policy to achieve and maintain 2% inflation. The central bank’s policy rate started the year at 0.25%.

The central bank said households with high debt levels have been successful due to the lowest interest rates during the pandemic. “All other things being equal, higher interest charges would significantly reduce their financial flexibility in the event of an income shock,” the central bank said. The analysis indicated that “an increasing number of households have made financial efforts to buy a home in the context of high house prices”. According to central bank calculations, the number of new mortgages issued with a loan-to-value ratio of 75% or more since the start of the pandemic has jumped by 40%.

The central bank added the vulnerability posed by rising house prices over the past year. April data indicates that existing home sales fell to a 20-month low and the benchmark price edged lower month-over-month. Preliminary figures for May suggest another decline in domestic sales and monthly prices could be in the offing. “It is too early to tell if the recent decline in resale activity and prices will be temporary or if this is the start of a deeper and longer lasting decline,” the report said, adding that rates Standard mortgages in Canada have risen rapidly to around 12-year highs.

In a note to clients this week, forecasting firm Capital Economics said the central bank’s aggressive communications on huge rate hikes risked sending the Canadian housing market into a tailspin, with house prices falling by more than 10% and the economy in a recession. The firm calculated that a key rate of 3% or higher would reduce what a homebuyer could afford by 23% compared to last year. Other economists say the Bank of Canada will be limited in how far it takes its key rate due to the economy’s exposure to rate-sensitive sectors, including housing. Housing contributed 20% to Canadian GDP growth last year.

Write to Paul Vieira at paul.vieira@wsj.com


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Don F. Davis