The road ahead for the economy and housing

Inflation in Canada has reached its highest level in nearly 4 decades prompting moves to raise policy interest rates with further hikes to come. The attention for many turned to what this means for future housing activity. Most important concerns focus on:

• what this means for the outlook for house price growth in Canada
• the industry’s ability to accelerate housing supply to begin restoring housing affordability in this country

Here, we try to answer some of these important questions and look at how different policy interest rates and economic scenarios will impact housing activity.

How will different interest rates and economic scenarios play out?

During the COVID-19 pandemic, household demand recovered rapidly after the initial sharp declines. However, the supply of goods and services has not matched demand recovery.

The war in Ukraine drove up energy and commodity prices, while China’s zero-COVID policy caused further supply chain disruptions. Both external factors have contributed to rising inflation.

The Canadian economy has rebounded from the pandemic. Strong economic growth and strong job creation have caused the unemployment rate to drop to an all-time low of 4.9%. As of early 2022, the Bank of Canada estimates that demand for goods and services is becoming greater than what the economy can produce in Canada¹.

This excess demand is a key source of upward pressure on inflation. To contain inflation, the Bank of Canada raised its policy interest rate 3 consecutive times, totaling 125 basis points from March to the end of June 2022. The current consensus among economists predicts further policy interest rate hikes from the Bank of Canada.

Because of the pervasive uncertainty, CMHC developed 2 scenarios to understand potential impacts on housing: a moderate and a high interest rate scenario.

The moderate scenario details a policy interest rate that reaches 2.5% by early 2023 and then stays at that level until the end of 2025. At 2.5% the policy interest rate reaches a level that is neither stimulating growth in the economy nor causing it to contract (the neutral policy rate).

In this scenario, the moderate rise in interest rates is assumed to be sufficient to control inflation given the sensitivity of households to rising rates due to their large debt loads.

In the high interest rate scenario, more actions by the Bank of Canada are required to prevent excess demand from triggering spiraling prices and wages in response to higher inflation expectations. This more aggressive response would be needed to slow growth in the economy, which allows excess demand to dissipate and allow inflation expectations to moderate and to bring overall inflation back to its 2% target.

In this scenario, the Bank of Canada hikes more aggressively and increases its policy interest rate to 3.5% in early 2023 before gradually converging back to the neutral rate of 2.5%. In both scenarios, inflation gets back to the 2% mark by the end of 2023.

^[1] https://www.bankofcanada.ca/wp-content/uploads/2022/04/mpr-2022-04-13.pdf

Monetary policy affects other macroeconomic variables. The moderate scenario sees Canadian GDP (Gross Domestic Product) grow by 4.1% in 2022 and 2.2% in 2023. External factors contributing to inflation disappear by 2023. Therefore, the strong growth of the economy is supported by both the demand and supply of goods and services. On the other hand, the higher rise in the policy interest rate in the high interest rate scenario results in lower growth. Here, GDP is predicted to grow by 3.4% in 2022 and 0.7% in 2023. Economic growth hits a bottom between Q4 2022 and Q1 2023. These two quarters register marginal negative growth, signifying a mild recession in the high interest rate scenario.

In both scenarios, the economic slowdown causes an increase in the unemployment rate. The unemployment rate rises from its all-time low level of 4.9% in June 2022 and converges toward 6.2% in the long run. The high interest rate scenario sees the unemployment rate peak at 7% in early 2023, a result of weaker economic conditions.

Other interest rates will also rise with policy rate increases. In the high interest rate scenario, both the 10-year Government of Canada bond yield and conventional 5-year fixed mortgage rate rise quickly in mid-2022. At the end of 2022, the 5-year fixed mortgage rate reaches 5.7%. In 2023, bond and mortgage rate declines correspond to policy interest rate normalization and an economic recovery.

What do these scenarios mean for Canada’s housing markets?

Rising rates will cause economic growth to slow. This leads to higher unemployment and less wage growth, which coupled with higher mortgage rates will make access to home ownership more challenging. Equally, rising rates will increase construction costs, mainly due to increased financing costs. Compounded with surging material costs and labour shortages, this constrains housing supply. Taken together, the Canadian housing markets are expected to experience a downturn by mid-2023.

The high rates of house price increases during the last two years have been unsustainable. The cost of housing reached levels that are unaffordable for a large share of new home buyers, translating into a slowdown in 2022. The expected increases in borrowing costs contribute to a further slowdown in house price growth in 2022 and 2023. In the high interest rate scenario, the national average price remains elevated but is set to decline by 5% by mid-2023 compared to its level in early 2022. In the same forecast period, the moderate interest rate scenario sees a 3% decline.

Mortgage rates eventually start to stabilize in 2024. Supported by rising household income and higher immigration, house prices are expected to return to positive but moderate growth. Elevated price levels persist over the forecast horizon placing pressure on homeownership affordability. As referenced in CMHC’s Canada’s Housing Supply Shortages: Estimating what is needed to solve Canada’s housing affordability crisis by 2030, this would then lead to more pressure on the rental segment. Potential homeowners will stay renting longer and rental vacancy rates will be even lower.

Housing starts are expected to decline from their record levels in 2021 but remain elevated in comparison to their long-run average.

In the short run, housing starts are constrained by:

• labor shortages 
• surging material costs and
• increasing financing costs due to rising interest rates

However, high price levels will continue to motivate housing starts. The combined effects lead to slightly declining levels of housing starts. In the long-run, new home construction remains elevated compared to historical averages. They are supported by high prices and population levels.

Home sales projections remain elevated compared to their pre-pandemic averages but are lower than their 2021 peak. This downward trend reflects the cooling impact of rising mortgage rates and lower housing affordability.

By mid-2023, national housing sales will decline by 34% compared to their level in early 2022 in the high interest rate scenario, while the moderate interest rate scenario sees a 29% decline. Stabilizing mortgage rates and an economic recovery from the downturn in 2023 cause home sales projections to recover and converge to their long run trend.

What could worsen this outlook?

Presenting these scenarios don’t account for all downside risks to these forecasts. Further geopolitical tensions could increase commodity prices while reoccurring COVID outbreaks could prolong supply-chain disruptions.

Both possibilities would lead to high inflation persisting in the short to medium term. Monetary policy may need to tighten even more with rates staying high longer than in our high interest rate scenario to tame households’ and firms’ expectations and bring inflation back to the 2% target.

In the worst-case scenario, this could result in stagflation.

The global financial system could weaken, burdened by high inflation rates and bigger government and private debt levels. Economic weakness among Canada’s trading partners and higher global interest rates would follow. This would weaken the Canadian economy through lower exports and less access or higher cost of access to capital.

Finally, demand for homeownership could decline further than expected, with prolonged higher cost of living and the cost of borrowing still being elevated. A preference shift towards more affordable homes or regions could skew average prices further.

The economy and housing markets have seen significant volatility as the pandemic unfolded. We expect uncertainties will remain over the short term. CMHC will continue to monitor and report on these markets to help Canadians better understand uncertainties and what it means for them.