It’s Difficult to Make Predictions, Especially about the Future

Making predictions about economic growth and inflation is difficult. Look no further than the massive forecast misses of the past few years. While central banks employ hundreds of highly trained economists, they have little, if any, edge over private sector analysts in projecting these variables. However, policymakers do have special insight into the financial system.

Due to their regulatory and oversight roles, officials can employ financial data unavailable to the public. From their access to loan-level statistics used to assess the risks of mortgage renewals to the special trade data on the repo market used to understand the recent upward pressure on repo rates, it’s clear that policymakers have an edge in identifying and understanding the evolution of financial stability risks.

When it’s released on May 9, the Bank of Canada’s annual Financial System Review (FSR) publication will operate as the most prominent dissemination of this information. Last year’s iteration highlighted important financial risks, most notably the ability of households to service their debt.

It’s a topic that we’ve published on extensively. The good news in the 2023 FSR was that the central bank’s simulations came to similar conclusions as our own, giving us confidence in our forecasts, which must rely on a more limited set of statistics. The bad news was that those simulations suggested that the share of households experiencing financial stress is likely to rise in 2025 and 2026.

Since the 2023 FSR was published, the median household debt service ratio (DSR) and the share of new mortgages with DSRs above 25% have both risen. As the FSR said at the time, “Higher DSRs reduce flexibility for borrowers who experience unforeseen increases in expenses or losses in income.”

A year ago, the unemployment rate was 5.1%. Today it’s a full percentage point higher at 6.1%. Thus far, there’s only been a slight increase in mortgage arrears. There’s also been a stabilization in house prices over the past year, meaning that homeowners have not seen their equity further eroded. But the wall of mortgage renewals will only really begin to bite in 2025.

Today, financially stressed households are more likely to be renters. The high cost of living, including rent prices and interest rates, as well as perceived job risks are causing many renters to worry about their finances.

So, while the Bank of Canada might conclude once again that mortgage holders are weathering the storm, central bankers will have to add renters to their list of worries in this year’s FSR.

There’s no silver bullet for reducing the financial stability or economic risks emanating from these household vulnerabilities, but a comprehensive plan to lower inflation and then lower interest rates is key.

Reducing the pace of growth in the cost of living will help the incomes of Canadians catch up to, or at least narrow the gap with, the current high level of consumer prices. Lowering overall inflation will also open the door to potential rate cuts. Clearly high interest rates are making households and businesses more vulnerable to any other shock that could materialize, as well as weakening economic activity and employment growth. Getting interest rates down in a sustainable way will therefore reduce the overall risks to the financial system.

No one knows what economic or financial shocks the future may hold. While the Bank of Canada will no doubt find that financial stability risks are currently contained, beginning a gradual rate cutting cycle could help ensure that they stay that way.