Leave the ‘Waiting Room’Bank of Canada’s role in lowering the policy rate

“I am a patient boy, I wait, I wait, I wait, I wait …”  This opening line to the classic 1988 punk-rock anthem Waiting Room, by Fugazi expresses the sentiment that is currently felt on the Canadian housing market while we wait for the Bank of Canada.

Indeed, there’s a pervasive belief that until the Bank cuts its policy rate, potential homebuyers will be content to stay on the sidelines, and buyers may be extra hesitant given the Bank’s pause followed by further rate hikes last year. Even a significant fall in fixed mortgage interest rates since the start of the year did not provide the usual boost to demand.

What is the Bank of Canada still waiting for, and what are they looking for before they finally relax the monetary policy reins?

We need an inflation trend that is at or close to the 2% target.

The answer is simple. The Bank of Canada was mandated to do so by the federal government. Its goal is to keep inflation at or near two percent on a medium-term basis. While it’s true that the 12-month change in headline Consumer Price Index (CPI) fell to 2.7 per cent in April 2024, the Bank needs to see a sustained trend of inflation at or very near its target before feeling comfortable taking its foot off the brakes of the economy.

It is possible to argue that inflation has already been a lot lower than the headline CPI, or even core inflation measurements. The impact and source of housing cost inflation is the reason. 

Shelter costs rising due to factors outside Bank of Canada’s reach

Renting costs make up the remainder of the CPI. Close to 30% of the CPI is accounted for by shelter costs. The largest portion of this percentage comes from ownership costs, such as mortgage payments and home values. Shelter inflation is currently at 6.5 percent year-over-year.

If the high rate of shelter inflation was due to an overheated economy that is generating large job growth and income gains then monetary policy would have a clear role to play in slowing things down. The Bank of Canada has no control over the factors driving the rise in shelter costs. 

Record high net migration of non-permanent residents pushed up demand for rental housing, while the Bank’s own interest rate hikes drove mortgage payments much higher. On the supply-side, high borrowing costs for developers could impede new housing starts, and prevent new housing supply from reaching the market. 

Interest rates are not helping any of these causes. If shelter costs were excluded, Canada’s inflation trend is just 1.2 percent over the past year and well below 1.0 per cent when annualized for three months. By this measure, the Bank of Canada is already at risk of falling behind on inflation. It will cause unnecessary harm to Canadians by keeping rates high despite low and falling inflation. 

Calculation of the amount to cut based on economic equilibrium

How much should the Bank cut its rates by? The answer can be found in the Bank’s estimate of its “neutral rate” or, in plain language, the level of the Bank’s policy rate such that the economy is in “equilibrium” (everyone joining hands and buying the world a Coke, cats and dogs living together in harmony, Maple Leaf and Canadians fans sharing a beer … that kind of thing).

The Bank estimates that the equilibrium rate occurs between 2.25 and 3.25 percent, with a likely destination in the long run right at 2.75 cents. The Bank is cautious, and moves in increments of about 25 basis points to evaluate the effects of monetary policy changes on the economy. It is likely that the Bank will return to 2.75 percent over a period of two years.

Fixed mortgage rates to stay the same

Now for the bad news — the bond market, and by association, the mortgage market, is a machine that digests all available information about current and future economic conditions. Since late 2023 markets have anticipated falling policy rate. The entire expected rate cut has likely been priced into the five-year fixed mortgage rate.

Even though the Bank of Canada is lowering its policy rate, it may not be enough to bring down the rates on fixed-rate mortgages of five years, which are currently at around five percent.

The best mortgage rates are probably still ahead of us. Perhaps it’s time for both the Bank of Canada and potential homebuyers and sellers to move on and get up from the waiting room. 

Please note that BCREA does not respond to any comments made on its online articles.