Getting Comfortable with “Transitory” Again

In Canada, nothing breaks the ice better than a discussion about housing, and the Bank of Canada Governor has a few thoughts on the topic. Tiff Macklem contends that monetary policy shouldn’t be counted upon to improve housing affordability given the structural constraints in the homebuilding sector. Yes, addressing the housing shortage will require a multifaceted approach. But monetary policy does play a role in supply. For example, Quebec’s home building industry is more concentrated in purpose built rentals than elsewhere. Internal rate of return calculations play a much bigger role in the decision to build purpose-built rental housing than in the decision to build condos, which rely heavily on presales. This partly explains the significant 32% drop in housing starts in Quebec in 2023, which contrasted with more resilient outcomes in cities like Vancouver and Toronto. While other policy tools and industry sector innovations should unquestionably be prioritized to help expand housing supply, the role of restrictive financing conditions shouldn’t be downplayed.

The fact that the Bank of Canada Governor addressed the issue of housing in his speech is also related to the fact that, to a large extent, Canada’s inflation persistence reduces to the impact of shelter. Excluding shelter, inflation is running at a quite benign 2.4% year-over-year. The central question for the Bank of Canada should therefore be whether the economy is slowing enough to believe cycle-sensitive inflation components will continue to cool sufficiently to bring headline inflation down to 2% reasonably soon.

We don’t see any real reason to doubt the effectiveness of Canada’s current monetary policy. Were it not for historically strong demographic growth, monetary policy would have tipped Canada into a recession last year. As the economy forges deeper into excess capacity, rate cuts will become warranted in the near future. But the Bank of Canada will need to live with a few things as this process unfolds.

Will there be a response in home sales and prices? Probably, yes. In fact, data for Montreal, Toronto and Vancouver suggests buyers have started to come off the sidelines lately. But there’s a difference between a transitory, pent-up-demand-driven rebound and a strong, sustained housing market rally.

It’s not just the daunting affordability economics that challenge many buyers today, but the broader economic landscape has shifted significantly in the past year. Early last year when the housing market recovered, the unemployment rate was at 4.9% and insolvency rates were relatively low. Fast forward to today, and we’ve learned that consumer insolvencies surged by 23% in 2023. Meanwhile the unemployment rate has climbed to 5.7% and probably hasn’t peaked, financial institutions have tightened their lending conditions, and households are hesitant to make major purchases.

What if we’re underestimating pent-up demand? If demand proves stronger than anticipated, prices and affordability will naturally adjust to bring the market into balance with the available supply. Given today’s record-low affordability, it wouldn’t be misguided for the Bank to adopt a hands-off approach and allow market dynamics to regulate housing activity.

What else will central bankers need to be at peace with? Supply shocks. Before the pandemic, supply shocks were a normal part of life that didn’t typically cause central bankers to lose sleep. So it’s at least encouraging to see the Governor again acknowledge the transitory nature of some factors. In a note next week, we’ll tease out some of the ways shipping disruptions in the Red Sea could affect inflation if freight prices remain elevated. But it’s more likely that these disruptions are just transitory. That’s why it’s central bank best practice to discount relative price shocks of this variety.

Even when we think back to the pandemic, it wasn’t so much supply chains that prompted the aggressive monetary policy response to inflation, because central banks correctly identified the supply chain disruptions as temporary. Arguably to a greater extent, it was a confluence of demand-boosting fiscal policies, supply shocks via public health restrictions, and the war in Ukraine which acted as an accelerant, that collectively told central banks they needed to react forcefully. The parallels between current supply chain disruptions and the pandemic are therefore quite limited. What we’re seeing right now is in all likelihood a transitory shock, and central bankers are well within their right to say so. Hopefully they will. Because truth be told, if they wait for guarantees—whether on supply shocks, housing gyrations, wages, short-term inflation measures or government spending—there will always be a good excuse to delay rate cuts.