09/18/2024
Statistics Canada released their monthly inflation data this morning.
This release is a big one, as inflation for August came in at 2.0% year over year. This is below the projected rate of 2.1%, down from 2.5% in July and marks the first time since interest rate hikes and economic tightening began that the rate of inflation is officially at the Bank of Canada's target range.
You'll probably see all your friends in the housing and finance industries come out of the woodwork to loudly proclaim that this is the time to buy a home/get a mortgage/take out a loan/buy a car etc. You surely have to get in now before prices inevitably rip higher once interest rates go back to where they were, right?
Is that true though? What does all this mean, and what's the effect of inflation having reached the target?
Well for one thing, it further entrenches the expectation that mortgage rates will continue to fall heading into the end of the year and into 2025. The economy has been slowing, unemployment rising, and we have been in a "per capita" recession for roughly 2 years. A per capita recession means that the GDP of the country, divided by the population, has continued to fall while the headline GDP has not. This is due to the high levels of population growth from immigration. The economy is larger because there's more people in it, but each person's share of the pie is relatively smaller than it used to be.
An interesting component of the CPI inflation numbers for some time now has been mortgage interest. This month, and in many that preceded it, mortgage interest costs have been the largest single upward contributor to the inflation numbers. For August, CPI excluding mortgage interest costs was 1.2% year over year.
The reason this is a worthwhile observation is that the interest rate hikes implemented to control inflation and reduce the supply and velocity of money have become the largest contributor to inflation, which seems counterintuitive. This was true in reverse as inflation began increasing in 2021, with interest rates at record lows the inflation numbers were artificially suppressed which is a part of the reason why inflation peaked once mortgage rates began to increase in 2022.
This is all to say that CPI as a measure of inflation is a lagging indicator. It doesn't really tell the story of what's happening today, but more what's happened over the last year or so. Inflation that trends up is not immediately reversed by increasing interest rates, nor is a downward trend immediately reversed when rates are lowered.
As interest rates begin to decline, the base effect they have on inflation will start to fall off. As mortgages are renewed at comparably lower rates, the mortgage interest component of the CPI will decrease, and the headline inflation numbers will follow suit. Furthermore, given the deteriorating economic backdrop, it's reasonable to conclude that other measures of CPI inflation will continue to decline as well.
Another notable observation from this month's data is that footwear and clothing prices fell month over month from July. This is highly unusual as the seasonal demand from back to school shopping typically creates a seasonal increase in this area. The last time that footwear and clothing prices fell in August was in 1971...53 years ago. This is an indication that the consumer is weak, and that retailers were left with excess stock despite the seasonal uptick in demand.
It is my opinion that the Bank of Canada is late to the party in reducing their overnight interest rate, just as they waited far too long to begin increasing borrowing costs in 2021-22 as inflation was on a clear upward trajectory.
The estimate for the neutral rate right now is 2.5%, compared to our current rate of 4.25%. This would mean that in order for the economic policy to be neither stimulative nor restrictive, the overnight rate would need to fall by roughly 1.75% from where it is today. For those with variable rate mortgages, every 0.25% decrease in rates represents a monthly payment decrease of roughly $14 for every $100,000 owing.
For example, if you currently have a $500,000 mortgage today and your interest rate is 5.45% (prime-1%, which is common), your payment is $3037/month. If rates fall to 2.5% overnight, your interest rate will fall to 3.7% and your payment to $2549. A difference of $488 per month.
Given that they are already late in reacting to the downward trend in inflation, it would likely be prudent for the central bank to accelerate the pace of interest rate cuts and try to reach the neutral rate fairly quickly so as to avoid further economic deterioration that would necessitate a return to the abnormally low interest rates we saw from 2010 to 2017 and again from 2020 to 2022. If the economy falters badly enough, they will be forced to reduce borrowing costs until positive signs appear which could risk reigniting the speculative bubble in asset markets that we saw a couple years ago.
You know, people paying $1 million for a digital image of a monkey or a dilapidated house in a bad neighbourhood because they assumed the value of those things would only continue to increase.
Prediction is a difficult business, and most predictions are wrong.
That said, if I were to wager what's about to happen:
- inflation will continue to ease- economic indicators will continue to deteriorate
- the central bank WILL NOT react quickly enough
- interest rates will continue to decrease slowly, before being cut very quickly once they start to hit the panic button (remember the tepid start to increases in the overnight rate from a couple years ago and the jumbo sized hikes that followed?)
- the decrease in interest rates will not be enough to quickly reduce the trend and in response to low inflation readings and a slow economy, rates will be reduced further.
Overall, I think that within less than a year we will see the overnight rate reach somewhere in the area of 2.25-2.5%, which I'm fairly confident of barring any unexpected geopolitical shocks that might put sudden upward pressure on prices.
As far as how low interest rates might go at the bottom of the upcoming cycle of loosening monetary policy, I would wager my guess at somewhere between 1.5 and 1.75% overnight rates. This would translate to variable rate mortgages in the high 2% to low 3% range. I do think that central banks will collectively be very cautious of decreasing rates further after the experience we had in recent years, so again barring major geopolitical shock I think this the likely lower range.
Remembering back to 2018 and 2019, the overnight rate was at 1.75% and the economy largely seemed to be in a good place so I have (a little bit of) hope that we might return to some semblance of normalcy here.
It's also worth pointing out that the highest interest rates could have been avoided had a more proactive approach been taken, and that too-low rates could so to be avoided if appropriate measures are taken to loosen monetary policy ahead of a major economic downturn.
As for what this means for the housing market...
It's hard to say, but my guess would be that we continue to see prices go mostly sideways for the next little while on detached and freehold properties while condo units (particularly smaller ones) likely continue to see some downward movement in valuation due to the oversupply caused by the overbuilding of small units to sell to speculative investors.
If you're looking to purchase a home or to make a move in the next year or so, please be careful not to get caught by what could be a rather volatile time in the market. As we've seen, one month it can be very difficult to sell a home and the next people seem ready to line up for a bidding war again. As interest rates fall and economic conditions deteriorate, it's likely that this continues to be the case as sentiment see-saws between fear of worsening economic conditions and the perception that lower interest costs will spur increased demand and higher prices.
If you'd like some advice, feel free to shoot me a message so we can chat about what your options might look like. As always, it's important to make sure you're informed about the risks and potential rewards of any large financial decision.
I don't mean from myself, but from those who know far more than I do and have lived through these cycles before. Seek out a trusted financial advisor, friend or relative who's well informed and ask for their honest advice. After all, advice is much more genuine and valuable when it comes from someone who's vested interest in your decision is your own well being rather than the financial reward that potentially comes with it.
I'm a Realtor, which means I work in the industry every day and I've seen huge amounts of bad advice, often steeped in self interest over the last few years. While I try to be as honest and well informed as possible, it's impossible to entirely separate one's own interests from the conclusions one might reach. Even honest and well meaning advice is prone to cognitive bias....that's just human nature, and no one is immune.
