Today we are combining two traditions – one old and one new. The oldest tradition, dating back more than a decade, sees the Governor of the Bank of Canada talking about the state of our financial system in an end-of-year address in Toronto. The newest tradition, which began earlier this year, is to offer an Economic Progress Report four times a year, following interest rate announcements that do not come with our Monetary policy report (MPR), just like yesterday.
My motivation to combine these two traditions is more than just trying to increase productivity. Ten years ago, the global financial crisis gave us the preconditions for a repeat of the Great Depression of the 1930s. Thanks to aggressive fiscal and monetary policies, we avoided this. But a decade of great monetary stimulus has led us to a critical phase of the economic cycle.
The Canadian economy has been operating close to its capacity for more than a year, unemployment is at its lowest level in decades and inflation is on target. Historically, this is the point in the business cycle where inflationary pressures may begin to develop, so it is only natural that we are looking to move interest rates to a neutral level. At the same time, the decade of exceptionally low interest rates led to an increase in household debt, made up mostly of mortgages. And we are all aware of the large increases in house prices in recent years, particularly in some of our larger cities.
These financial vulnerabilities have made monetary policy more complicated. Understanding them and integrating them into our policy process has been a priority for the Bank. Meanwhile, the world has not stood still since our last MPR in October. In fact, there were more macroeconomic developments than usual. My focus today, therefore, is to update it and define how concerns about financial stability are captured in our decision-making process.
The growth of financial vulnerabilities
Let me start with a few words about how our financial vulnerabilities have become so great to begin with. The fact is that debt accumulates during the recovery phase of each economic cycle. Low interest rates stimulate recovery by encouraging families and businesses to take out loans. Usually, the economic cycle is short enough so that the risks posed by these imbalances are relatively small.
Of course the last 10 years have been far from normal. Interest rates have been extraordinarily low for an unusually long time. The inevitable result has been the strong demand for housing, rising house prices and the accumulation of family debts of historic proportions. The associated accumulation of financial vulnerabilities has been a concern of the Bank for several years. In fact, household indebtedness in Canada was increasing sharply long before the global financial crisis, mainly as a result of a relaxation of mortgage rules about 15 years ago, financial innovation and falling interest rates.
In response to these developments, the federal government has implemented a series of more restrictive macroprudential policies – designed to ensure that new loans are safer. In particular, with the revised B-20 guideline, which came into effect earlier this year, all new mortgages from regulated federal institutions were subject to some sort of stress test to ensure that borrowers could handle an increase in interest rates. You can find much more details about this and other stability issues at our Financial System Center on the Bank's website.
Now, I hear all the time from people who say that this stress test should not be applied in real estate markets that are not overheating. But the turning point for the B-20 was not to cool the real estate markets. The aim was to increase the future resilience of new household debt. All Canadians face the risk of higher interest rates, not just the hot-house markets.
Still, there is no doubt that the combination of these stress tests, higher interest rates and housing policies implemented by provincial and municipal governments are affecting household indebtedness. We are seeing a lot less mortgages being taken for reasons of debt over income than 450%. And credit data shows that mortgage debt growth slowed this year to a rate of just over 3%. At this rate, the aggregate debt-to-income ratio is likely to trend moderately downward.
In defining monetary policy, it is crucial to unravel the impacts of these various policies. We need to know how much of the slowdown in credit growth is due to higher interest rates, not to other policies. What is the size of the impact of higher interest rates on household spending? And how are the various macroprudential policies, including guideline B-20, affecting the behavior of borrowers and home builders?
Clearly, there is no way to get accurate answers to these questions. But we need to understand how the evolution of the financial system affects the real economy and the risks it faces. I talked about this subject almost four years ago during a lecture at Western University. I talked about the idea of developing a grand synthesis – a utopian economic model, capturing how the financial system would affect the real economy and vice versa, and helping us to fulfill our inflation control mandate.
We can never achieve this utopia. But the good news is that we have made significant progress. Let me mention three major improvements.
First, a new concept developed at the International Monetary Fund – growth at risk – is now being used by Bank staff to help us understand the links between the financial sector and the real economy. It captures the increase in financial vulnerabilities and the negative risks to the economic growth associated with them. Thus, when contemplating a change in interest rates, we can estimate both the usual direct effects on the economy and the indirect effects through the channel of financial vulnerability. The growth-at-risk structure is not the big synthesis, but it gives us a more rigorous way of thinking about financial vulnerabilities within our risk management policy framework.
Second, we have updated our main economic model to incorporate the accumulation of household debt and thus capture the fact that the economy is more sensitive to interest rate movements when debt levels are high. It also embraces the link between debt accumulation and rising house prices. These are important steps to help us understand the impact of these vulnerabilities on the economy.
Third, the World Bank team is working with new sources of microdata to deepen our understanding of how higher interest rates affect mortgage holders. We now have access to anonymous data at the individual lending level since 2014, covering about 85% of mortgage lending over that period. This includes information about the size of the mortgage, the family income, the origination interest rate, the mortgage term, and the repayment period.
These data allow us to calculate how households are being affected by higher interest rates through the mortgage renewal cycle. When estimating the effects of higher interest rates on monthly household expenses, we can predict how spending on other purchases will also be affected.
So far, this improved framework has performed well for our forecasters. However, it is important to remember that so far, most families are renewing mortgage rates that are quite similar to the rates they signed five years ago. As we move forward, people will increasingly face higher interest rates as they renew, and we will learn more about how people are adjusting.
Of course, many highly indebted households will face a difficult adjustment as their mortgages are redefined and interest rates rise. Still, these adjustments will be far less demanding than if there were a serious negative economic shock, especially if financial vulnerabilities could continue to grow uncontrollably.
Now the fact that household spending is behaving more or less as expected gives us more confidence that we understand what is going on in the economy. But borrowers and lenders continue to adjust to rising interest rates and new mortgage rules. Therefore, we are closely watching various trends in mortgage markets. For example, the share of mortgages originated outside federal jurisdiction, including private creditors and credit unions, is increasing. These borrowers are not subject to a formal interest rate stress test. We have seen an increase in mortgage lending by private lenders in the Toronto area, although we do not have this kind of data for cities outside of Ontario.
We also saw a larger portion of heavily indebted borrowers taking on variable rate mortgages. In doing so, they are reducing their debt service charges because usually the interest rate on a variable rate mortgage is lower than on a fixed rate mortgage. This frees up money to spend or save in the short term, but exposes borrowers to unexpected increases in interest rates in the future. That being said, the stress test in effect gives us confidence that these borrowers can manage significantly higher payments if needed.
In summary, while the quality of new loans has improved, the stock of risky mortgages remains high. Over time, these mortgages should become less risky as they are slowly paid off. Still, this vulnerability will persist for many years.
Closely related to the accumulation of household debt are developments in the housing markets. Everyone is talking about this issue – not surprisingly when you see that home prices in the Toronto area are about 40% higher than three years ago. In the Vancouver area, the increase was even greater – about 50%. Outside these two areas, the average house price increased only 5% in the same three years.
To be clear, key factors raised house prices in Toronto and Vancouver. Strong population growth and employment supported the demand for housing. The cost of various inputs, such as construction labor and development rates, has also increased. At the same time, various policies and other factors have limited the growth of supply in both places. If supply does not expand in a climate of strong demand, you have a recipe for rising prices.
That said, it seemed clear to us that price growth was being amplified by speculative activity, particularly during 2016-17. Some buyers were speeding up their purchases, motivated by the fear that they would be left with the price out of the market if they waited. Others, mostly investors, were buying real estate on the assumption that prices would continue to rise. This is significant because when speculative activity raises prices unsustainably, an economic shock can cause a sharp decline. Anyone who remembers the real estate market of the early 1990s in Toronto and Vancouver will recognize that point. And the impact of such a downturn is magnified when homeowners are highly indebted.
The Bank raised the main policy interest rate five times over the last year and a half, for a total of 125 basis points. And I have heard from some Canadians, more recently, who are concerned about the impact of these increases in the rate of accessibility of housing. However, given the combined impact of provincial and municipal housing measures and stricter macroprudential policies – not to mention higher interest rates – home prices for Canada as a whole are growing at an annual rate of approximately 2%. It seems to me that this slowdown in housing price inflation is much more significant in terms of accessibility for first time home buyers than the interest rate movements we have seen. The basic laws of economics say that measures to increase supply would be the most effective way of supporting accessibility. And measures that increase demand, without corresponding increase in supply, can worsen the accessibility of housing.
Speaking of the upward trend in interest rates, a risk related to Canada's financial stability that we have closely observed is that of a snapback in global interest rates. Because Canada would normally import about 60-70% of any increase in global bond yields, we would see the resulting effects on our mortgage rates, even if the Bank of Canada's interest rate were kept unchanged. This risk remains at the forefront, particularly given the volatility of the bond and stock market in recent weeks. Most observers would argue that the likely catalyst for such a risk would be an inflationary surprise from the United States, whose likelihood has increased with the response of the US economy to fiscal stimulus. However, our outlook is that the US economy will moderate to a more sustainable pace next year and 2020 and that inflation expectations will remain well anchored.
So let's summarize the situation of financial stability. Board judges that the overall level of risk for the Canadian financial system is approximately the same as that of six months ago when we Financial System Review. New mortgage loans are more solid and housing price growth has slowed. However, households' debt stock will remain high for years, and house prices remain high in certain markets. Our new growth-at-risk structure clearly shows that macroprudential policies have been working to mitigate the risk of financial stability, thereby improving the risk management problem faced by monetary policy.
Macroeconomic Risks and Inflation Perspectives
Let me now turn to macroeconomics. As we said in October, the economy has been operating close to capacity for more than a year and inflation is on the way. Since October, there have been a number of important developments.
First, there have been growing concerns about a global economic slowdown. I would like to note that our forecasts already called for moderation of economic growth in 2019-20, but that would only lead us to a path of sustainable growth and would not be a cause for concern. However, the main risk we see for this prospect today is the trade tensions between the United States and other countries, particularly China.
Rising tariffs will slow down economic growth and reduce productivity on both sides, as well as raising inflation risks – a combination we often call stagflation. This combination is particularly challenging for monetary policy since it forces a trade-off between cushioning economic growth through lower interest rates and containing the risk of inflation with higher interest rates. Because the effects on the economy are likely to be more structural than cyclical, I have to believe that curbing inflationary risks would become central to a direct trade war.
It is important to note that the risks surrounding global trade are bilateral. Yes, there is growing evidence that commercial stocks are already having negative macroeconomic effects. But as central bankers, we can not just focus on the worst case scenario. The positive risk is that the United States and China will reach agreement and the global economy will enjoy a new source of support. This past weekend's events in Buenos Aires were somewhat encouraging on that front. So we continue to weigh both sides of the issue.
In terms of the Canadian economy, it is fair to say that the data released since our October MPR were disappointing. Although GDP data for the third quarter was close to our overall expectations, the underlying composition of growth was not, and the economy has less momentum going into the fourth quarter than we believed.
Although recent housing data were lower than expected, we believe this is the result of a significant adjustment in new home construction for multiples, and this adjustment prolonged the slowdown in housing construction that began earlier this year . Population and employment growth, and therefore the fundamental demand for housing, remain strong. Credit growth has also stabilized, and all this confirms our view that the market is stabilizing.
Business investment declined unexpectedly in the third quarter. We identified at the beginning of the year the likelihood that uncertainty about the future of NAFTA might delay investment decisions. It seems now that this effect was very strong during the summer when uncertainty was at its peak. The other major factor restricting business investment was the delay in the Trans Mountain Pipeline project.
The CUSMA signature is likely to support a recovery in investment, particularly given current capacity constraints, although governments still need to implement the agreement. In addition, the fiscal changes recently announced by the federal government will lead to further strengthening of investment. This would also suggest continued growth in exports, which were supported by strong external demand but limited by tight capacity.
In its latest GDP release, Statistics Canada has revised down its historical estimates of economic growth. Most of these revisions refer to changes in economic structure starting in 2015, as the economy was adjusting to sharp declines in oil prices. It may seem strange that developments in 2015 may still be affecting our view of the economy in 2018, but they do. Currently, GDP is believed to be almost 1% lower than previously thought. The effect of this review on the inflation outlook will depend on how much of this change is in demand and how much is in supply or in economic capacity and therefore how our estimates of the difference between the two are affected. We'll talk more about it in our January MPR, once our review is complete.
Much of the Governing Council's discussion focused on oil. Global oil prices are well below our forecasts predicted in our October MPR, mainly due to supply forces. There is also an important overlap of concern in moderating global economic growth due to heightened trade tensions, with implications for future oil demand.
The main source of additional oil supplies is the same as in 2014: the United States. For reference, the world consumes about 100 million barrels of oil per day. In 2008, US production was about 7 million barrels per day. In 2014, the shale revolution raised that number to 12 million. Today, US production is more than 15 million barrels a day, more than double the 2008 level. That is 2 million more than a year ago, and US oil exports increased by the same amount during that year. period.
These developments in the US reduce Canadian output – we produce about 5 million barrels a day and export just over 3 million barrels a day. Weak global oil prices have a direct impact on Canada, as we well know from our experience in 2015-17. This affects all producers in the east and west. Although the Canadian economy largely completed its adjustment to lower oil prices by mid-2017, adjustments in the structures of costs, wages and jobs in the oil-producing regions continued. In fact, the share of oil and gas production in the Canadian economy has declined since 2014, from about 6% to about 3½% today.
The recent decline in world oil prices has widened in western Canada as the discount to our heavy crude, Western Canada Select, has risen to a record high. This is due in large part to transportation restrictions, but was aggravated this fall by maintenance shutdowns at some of the major US refineries. Since our October rate decision, the heavy oil rebate has narrowed somewhat, as US refineries have restarted. However, in the past few weeks, the discount has also spread to the Canadian light oil price, Edmonton Par, with stored inventory reaching record levels. Alberta's initiative to impose reductions in production and add more rail capacity will help clean the backlog, and more pipeline capacity would certainly help in the long run.
Although we have not prepared a completely new economic forecast for yesterday's decision, we will do so between now and our next decision in January. It is already clear that a painful adjustment is developing for western Canada, and there will be a significant impact on the Canadian macroeconomics. That said, given the consolidation in the energy sector since 2014, the net effects of falling oil prices on the Canadian economy as a whole, dollar-for-dollar, are expected to be lower than in 2015.
In short, then, as I said, a lot has happened since the October MPR. But let's not forget that these developments have come against the background of a 40-year unemployment rate and inflation close to the target, consistent with an economy that has been operating close to its capacity. Let's look at all these new developments in our new projections at the January MPR.
The Governing Council of the ECB yesterday determined that the current level of interest rates remains appropriate for the time being. And by weighing all these developments, we continue to judge that the policy interest rate will need to rise to a neutral level – somewhere in the range of 2.5 to 3.5 percent – to reach the inflation target. The pace at which this process occurs, of course, will remain decidedly dependent on the data. We will continue to assess the impact of higher interest rates on consumption and housing and monitor the development of global trade policy. The persistence of the oil price shock, the evolution of business investment and our assessment of the economy's capacity will also be important in our decisions about the future stance of monetary policy.
It's time to finish. I hope my speech has shown how financial vulnerabilities fit into our monetary policy discussions. We have made progress in thinking about these and other vulnerabilities and understanding the risks they pose to the economy. I have also tried to give you a sense of the many problems we are dealing with in managing the macroeconomic risks facing the Canadian economy. We will continue to manage these risks as we seek our mandate to control inflation and promote the economic and financial well-being of Canadians.
I wish you all a very happy holiday season and all the best in the new year.
I would like to thank Don Coletti for his help in preparing this speech.