Chad Moore Calgary Mortgage Broker

I think you’ve heard the narrative “inflation is rising” if you’ve browsed any business news over the past month. You’ve more than likely heard about the inflated prices of lumber, or have seen retail lumber prices ? Around a campfire, I find the general narrative to be there are inflationary concerns amongst people.

Ok, so inflation is definitely here today. Just like deflation was definitely “here” 12 months ago. The great unknown is will inflation be transitory (fade away) or be persistent (here for extended periods of time)?

If I go looking for reasons to support how inflation will be transitory, I can seemingly make a fairly solid argument:

• Supply constraints will subside.
• Demand will ease off when government benefits slow/stop.
• Demographic deflationary forces.
• Technological deflationary forces.
• Deflationary force due to debt.

If I go looking for reasons to support how inflation will remain, and or continue to rise, I think reasonable points can also be made:

• Central banks across the world are printing money at unseen levels, adding to the money supply.
• Demand for commodities will continue.
• Pent up demand for purchasing (re-opening).
• Huge amount of savings ready to be spent in the economy.
• Government stimulus is not stopping.
• Rising labour costs.
• Base effects.

Honestly, in my search to understand what might happen with inflation, I’ve concluded, and have witnessed many economists I respect, admit nobody knows how this will play out. Do you know what inflation will look like in 12-18 months? How?

For my readers, I think the exposure to risk is if inflation is sticky, or persistent. Let’s discuss what might happen in this scenario.

Inflation Risk To The Upside:

For many years, the previous governor of the Bank of Canada would talk about “bringing the economy home” from the Great Recession and Oil shock of 2014.

“Bringing the economy home” meant meeting our 2% inflation target, while absorbing slack in the economy.

“Absorbing slack in the economy” means closing the theoretical gap between full potential economic output and actual economic output. As this gap narrows, inflationary pressure rises. Why? Full economic output would mean low unemployment, and upward pressure on worker wages.

In today’s economy, the new governor of the Bank of Canada has been more vocal about getting employment back to pre-pandemic numbers and allowing average inflation to govern interest rate policy decisions.

Regardless of the verbiage, the mechanics of Central Banks around the world to combat inflation is to hike interest rates. Here’s how this effects the Mortgage market:

1. Fixed interest rates increase.
   
   As inflationary pressure rises, bond prices decrease, bond yields increase which shrink Mortgage lender margins. Mortgage lenders then raise fixed interest rates to maintain profitability.
   
   In this scenario, the Mortgage qualifying interest rate (stress test) would increase eroding home affordability. I’m writing future content on my thoughts related to this …
   
   
2. Bank of Canada raises the “key lending rate”.
   
   The Bank of Canada (BoC) raises the central interest rate in Canada. This interest rate influences the Prime lending rate at commercial banks (RBC, CIBC etc). The Prime lending rate is linked to open and closed variable rate Mortgages, personal lines of credit and more.
   
   In general, a 0.25% rise in rates will increase a variable rate Mortgage payment $12/mo for every $100,000 of Mortgage debt.

Let’s play this “inflation” scenario out together. What if inflation is here, persistent and does not go away. What might actually happen?

Inflation Bluff Called Out:

Ok, if inflation is here to stay, will rates actually increase?? Here’s my opinion …read above on how I acknowledge people much smarter than I do not know how our economy will play out. With that, my thoughts:

1. Rates would rise, but be capped.
   
   I think if bond yields rise to an uncomfortable and unworkable level that Canada’s housing market starts to suffer (I.E., decrease national home prices 10+%) the Bank of Canada will step into the market and suppress interest rates.
   
   Why? The BoC is already controlling fixed interest rates. They have already capped fixed interest rates in Canada. We are already under “yield curve control”. If inflationary pressures begin rising, and fixed interest rates move higher, I think the BoC will step in and cap them off (again).
   
   Canada’s housing market is a growing percentage of our national Gross Domestic Product (GDP, all goods and services produced) and is a significant portion of Canadian household net worth.
   
   The “wealth effect” of a higher and higher housing market is also helpful for the economy.
   
   
2. Debt sensitivity is much higher.
   
   Benjamin Tal, economist with CIBC, mentioned in a video interview that debt sensitivity levels in Canada are about double from where they once were 5-7 years ago.
   
   This means our economy will react to a 1% interest rate hike similar to how our economy would have reacted to a 2% interest rate hike.
   
   I think even if we see high inflation numbers, pinning the Bank of Canada to hike interest rates, one 0.25% rate increase will have a more pronounced effect on the economy, helping ease inflationary pressure. Because of this I do not think we are going to see rates run up too high as the level of debt in our country is at peak levels.
   
   
3. Uncertainty and lag effect.
   
   Think back to April 2020. Who was calling one of the biggest Real Estate bull markets in Canada one year later? We’re still living in a generational and global pandemic with emergency health, monetary and fiscal policy measures. There is still a reasonable amount of uncertainty in the economic outlook. Things can change, quickly.
   
   If there is inflationary pressure today, and a rate hike is decided, the effects usually take 12-18 months to show up in the economy. And the economy could be different at that time.
   
   One risk posed to the Bank of Canada is waiting too long to hike interest rates. Waiting too long could create a scenario where the Bank might have to “slam the brakes on” and hike multiple times. Mark Carney, former governor of the Bank of Canada made a “oops too soon” interest rate reversal in 2013.

The Reality Of Rates.

For the most part, Canada is a net importer of monetary policy. We’re a big global land mass, but a very small economy on a global scale. Remember, the state of California has about as many people as our country!

The Bank of Canada is likely not going to raise interest rates before the U.S. Federal Reserve. If that were to happen, the Canadian dollar would rise relative to the U.S. dollar and dampen our exports, setting our economy back.

Not long ago, the Bank of Canada’s position on reducing our asset purchase program (tapering) and the mention of “thinking about talking about raising interest rates” ahead of the U.S. Federal Reserve has the loonie appreciating over $0.81!

(a higher loonie is good for our Amazon purchases, but bad for our export economy).

Again, this loonie appreciation is simply the BoC “thinking about planning for higher rates”. The U.S. is not evening thinking about thinking about raising rates at this time (kind of comical to me).

Canadian policy makers think about talking about raising interest rates, while the U.S. Federal reserve is unwilling to even admit to thinking about thinking about raising rates …and the appreciation of the loonie rises! Crazy.

Conclusion:

Canadian policy makers are seeing inflation unfold and standing pat (hoping?) that inflationary pressure will be transitory. If inflation is transitory, with supply/demand forces smoothing out, any sooner-than-desired monetary policy tightening can be avoided.

If inflationary pressures are persistent, with other important economic indicators stalling (employment, wage growth etc) then policy makers and markets could be in a tough (yet interesting to me) spot. We could see rates increase, government intervention, or who knows what!

One sure fire way to slow Canada’s housing market is to tighten monetary policy. Until that happens, the lending, borrowing and buying spigots are wide open.

Thank you!

If you have a looming Real Estate transaction (sale/purchase) or a Mortgage need (renewal/refinance) make sure to reach out to me. Thank you in advance.

If you enjoy this content, you’re exactly who I’m looking to work with. Reach out to me! Please consider sharing and commenting below. What do you think will happen with inflation and policy moving forward.