Friday, November 30, 2012

Some Thoughts on Bank of Canada and House Prices

Deputy Governor of the Bank of Canada John Murray gave a speech to a crowd in New York on global rebalancing. I'm certainly not learned enough to comment meaningfully on his arguments and rationale but he did mention something in subsequent commentary about Canadian housing:
Canada's heated housing market appears to be cooling as desired, a senior Bank of Canada official said on Tuesday, although he noted that housing starts remain unusually high.

Housing prices and construction in Canada roared higher in 2011 amid low interest rates, sparking fears of a U.S.-style bubble. The market started to slow after the government tightened rules on mortgage lending in July, and policy makers hope to see a gradual softening rather than a crash.

"It's still early days. But we're certainly seeing evidence of movement and acceleration in the right direction," Murray told a business audience after giving a speech in New York.

"Some sort of smooth transition, at least on the housing side, is what we're looking for," he said.
An interesting comment for a "housing analysis" blogger! Murray is commenting that transitioning housing to a more sustainable level is something the Bank is looking for, and on which is likely advising the government to form fiscal policy. So we can play some guessing games as to what the Bank of Canada would like to see for a "smooth transition" and what that means.

What are the risks of high house prices and debts? Currently there is some risk of external economic shock to incomes, but absent that, with real rates depressed, debt-service ratios are currently for the most part manageable. If rates increase, however, this poses a significant headwind for the Canadian economy and worse could be almost impossible for policymakers to contain the fallout. Luckily, based on the yield curve, it looks as if rates have a good chance of staying low for a prolonged period, perhaps for the rest of the decade. The question then is what does Canada need to do in the coming years to ensure that when interest rates do rise she will not be caught out with excessive debt levels and overinflated asset prices.

Based on Murray's comments we have a smidgen of a clue what the Bank's and government's strategy is on the front of asset price reversion. It looks as if they are trying to pull of a "smooth transition" of prices back to levels that are able to be carried with historical interest rates. If prices continue at current levels (or increase) they will not have reverted quickly enough to stave off a big shock when rates rise. If prices fall too quickly this will lead to situations where a large swathe of owners are in negative equity situations, something that has knock-on effects to the broader economy. Given the assumption the Bank wants to control the band in which prices revert, we can do a quick calculation what that would mean for prices.

Say prices as a ratio to incomes are 40% above their long-term average. To revert prices to this range will require a 30% drop. To do this in seven years requires a -5% annual drop in the price-income ratio. Assuming incomes rise by 2% per year that means national prices need to drop at -3% per year for seven years to revert. If markets like Vancouver are, say, 50% overvalued, that will require prices dropping at -5% per year with 2% annual income gains to revert.

Prices do not often move in a straight line, rather we should expect that price drops will be more severe near the middle of the reversion and less severe near the ends. We can approximate this trajectory as a raised-cosine profile, say

P=(Pi-Pf)/2*cos(π*x/L) + (Pi+Pf)/2

where P is the price, Pi is the initial price, Pf is the final price, x is the year from start of correction, and L is the duration of the reversion target. Below are the year-on-year price change results for a 20% and 30% decline in prices:

Assuming the Bank of Canada is serious about price targeting we have some rough estimates of the level of annualized price drops required to pull off this delicate manoeuvre. As a reference, Vancouver looks to be on track for between -4% and -6% annualized price drops in the late winter of 2013.

But here's the thing -- if prices are to revert in a controlled manner, as regular readers of this blog know, this necessarily requires a certain ratio of for-sale inventory to prices. In other words, to ensure prices drop at a defined rate it will likely mean the government will need to control the level of sales. The only ways I can see them accomplishing such a feat are through controlling immigration intake -- not easy since they don't have much control on where immigrants settle -- and through credit availability.

In short, if the Bank of Canada is indeed "price targeting" so as to attempt to revert housing valuations to their long-term averages in the advent of future interest rate hikes, I believe we can expect further adjustments to controls of credit availability, both looser and tighter, over the coming years. It will remain to be seen how much capacity is left to accumulate additional credit, and where it can be stuffed!


patriotz said...

Say prices as a ratio to incomes are 40% above their long-term average. To revert prices to this range will require a 30% drop. To do this in seven years requires a -5% annual drop in the price-income ratio. Assuming incomes rise by 2% per year that means national prices need to drop at -3% per year for seven years to revert.

And there is the problem. You cannot take incomes as an independent variable when the % of GDP in housing-related sectors is far above normal and much of consumption is enabled by rising consumer debt. Falling house prices will reduce incomes and ability to borrow. It's a positive feedback loop for both rising and falling prices.

That's simply looking at domestic factors. Add an anvil like a bust in China and Wile E. takes the plunge.

Thanks Jesse for your work in this and preceding posts.

jesse said...

The "pro-cyclical" nature of incomes to house prices is something for consideration.

To keep Vancouver's prices from falling "too fast" will require additional sources of funds. That comes from either direct outside investment or additional credit growth. Credit growth going forward could end up on government BSs.

Note I have refined my graphs as per some feedback from a friend of mine. The drops over longer duration corrections are likely overstated due to income growth.

On the topic of income growth, Realtors in aggregate have seen their incomes drop by a fair amount in 2012. Most of the province's households will carry on with at-inflation or slightly-above-inflation income gains though the public sector is starting to feel the austerity pinch; it's the FIRE jobs that will get hit hard if the downturn is pronounced. Not sure about construction; I don't think it's quite a San Diego or Phoenix situation.