Are the Bank of Canada and CMHC Fuelling a Housing Bubble?

This month we explore the booming housing market in Toronto and across Canada and how new macro-prudential policies can be introduced to help cool the market. 

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Last month, both Bank of Canada Governor Tiff Macklem and the Canadian Mortgage and Housing Corporation (CMHC) CEO Evan Siddall indicated that they are concerned by “extrapolative expectations” and “excess exuberance” in the housing market — a concern I first wrote about in my December 2020 Move Smartly report.

“What we get worried about is when we start to see extrapolative expectations, when we start to see people expecting the kind of unsustainable price rises we've seen recently go on indefinitely, and they're basing their decision on those kinds of assumptions. … When we see people starting to buy houses solely because they think prices are going to go up, that is a warning sign for us. We are starting to see some early signs of excess exuberance.”
- Bank of Canada Governor Tiff Macklem

While policy makers are concerned about the types of narratives Governor Macklem notes above, they must also ask themselves if they have played a role in creating these narratives, an issue I discussed on a recent BNN Bloomberg interview.

To be clear, I’m not suggesting that policy makers caused the boom we are seeing in the housing market today. This has been largely driven by a Covid-19 pandemic-induced change in consumer preferences which is pushing buyers out of cities and into the outer suburbs in search of larger homes with bigger backyards. But the “Covid urban exodus” is not the entire story.

Most critics of policy makers have argued that the monetary and fiscal policy measures introduced at the start of the pandemic have overstimulated the economy. Of course, hindsight is 20/20, and at the time of the unprecedented economic lockdowns necessitated by the unprecedented nature of Covid-19, these fiscal and monetary measures were understandably deemed to be necessary.

It’s worth noting that the federal government made the prudent decision to delay their planned easing of the stress test which was scheduled to take effect in April 2020. The change would have made the test more dynamic ensuring that the mortgage qualifying rate is roughly 200 basis points above the average mortgage rate. As it stands today, home buyers are qualifying for their mortgage at a rate that is roughly 300 basis points higher than today’s mortgage rate. Even though mortgage rates have declined due to Covid-19, this decline did not materially impact how much home buyers can borrow.

That said, we still find ourselves with a booming housing market in Toronto and across Canada. Can new macro-prudential policies be introduced to help cool the housing market now? Certainly. However, I think policy makers continue to make their biggest mistakes in what they are saying or ‘signalling to the market’, not what they are doing policy-wise.

The difference between a housing boom and a housing bubble has less to do with a specific policy and more to do with the beliefs of buyers — specifically the belief that home prices will keep going up at a rapid rate indefinitely and if they don’t hurry up and buy now, they’ll never be able to afford a home. These are the same beliefs Governor Macklem raised concerns about last month.

These types of narratives can impact home buying decisions in a number of ways.

It typically leads to rapidly rising prices because home buyers believe that they need to pay 5% more than what a similar home sold for last month just to “get into the market” and win a home — especially when they find themselves competing with 50 other buyers for a home. This is largely the reason why home prices are rising by over 30% per year in many of the Toronto area suburbs at present.

Another side effect is that it can accelerate many first time buyer’s home buying decisions. A home buyer who was planning on buying a home in 2022, for example, will instead decide to move up their plans and buy immediately when they see prices rising 20-30% per year. It’s the only rational response when they believe homes will be significantly more expensive a year from now.

So what does a home buyer’s irrational exuberance have to do with the Bank of Canada and CMHC?

Most economists continue to believe that home buying decisions are driven entirely by rational factors like policy and macroeconomic changes in the market. In effect, home buyers are a bunch of “rational actors” who simply respond to what policymakers do, such as introduce mortgage stress tests, in an orderly and predictable way. Pull the policy lever down — more buyers buy homes. Push the policy lever up — fewer buyers buy homes.

Behavioural economists on the other hand don’t believe that we are as rational and predictable as economists like to think we are. They believe that our decision making is prone to biases and that collective narratives and beliefs can play a big role in our decision making.

In his book, Narrative Economics, economist Robert Shiller unpacks how narratives can drive major economic events.

So how have policy makers shaped the beliefs and narratives we are seeing in the market today? I’ve touched on some of these issues in past reports, but I’ll summarize them here for clarity.

The Belief: House Prices Can Only Go Up!

In 2020, at the height of the first round of Covid-19 lockdowns, CMHC forecasted that home prices in Canada will fall 9 to 18%.

The problem with CMHC’s messaging at the time was that their reports didn’t suggest that prices might fall, they said prices will fall. They were so certain of their view that they suggested that home buyers should question the motivation of anyone who suggests otherwise as merely “whistling past the graveyard.”

Many Canadians took the cautious narrative seriously.

When prices didn’t fall and instead accelerated rapidly in the third and fourth quarters of 2020, the narrative changed dramatically. The narrative Canadians took away from CMHC’s promise of a collapse in home prices was that if an incredibly deep, unprecedented pandemic-induced recession can’t take Canada’s housing market down, nothing will!

The Belief: Home Prices Aren’t Too High, There’s Nothing to Worry About!

By September 2020, it was clear that a housing market crash was not going to happen, sales were up by over 40% and prices were rising by double digits.

This is the time when CMHC should have stepped up to caution against exuberance in the market — but they didn’t. In September 2020, they were still sticking to their incorrect forecast telling people that prices were primed for a decline.

Not only did CMHC’s warning of future price changes get the direction wrong (they should have warned about rapid acceleration vs a decline) they actually concluded in December 2020 that there was low-risk of price acceleration, overheating or overvaluation in Toronto.

The Bank of Canada shared a similar narrative. Last month was the first time they expressed any concern about “early signs” of exuberance in the housing market, but even that was met with little concern; in response to house prices rising by over 30% in many Canadian cities, Governor Macklem had this to say last month: “[W]e’re a long way from where we were in 2016-2017 when things were really hot.”

The Belief: Prices Will Keep Going Up!

The Bank of Canada has had a consistent message since the start of the pandemic — interest rates will remain low for a long time and the Bank has a lot of policy tools available to ensure that the economy and housing market continue to boom.

Our central bank is effectively telling home buyers and investors that they will do everything possible to keep the housing boom going. They have made cheap money and rapid house appreciation the “new normal” which is materially influencing how home buyers behave.

These narratives and beliefs about the future direction of home prices lead home buyers to speed up their buying plans and have helped to push prices up by over 30% in the Toronto Area suburbs.

In a recent thoughtful Twitter thread, CMHC CEO Evan Siddall did acknowledge that CMHC could have been clearer about their forecasts.

“We meant to contribute to a discourse, even though it was hard to be precise about future. In hindsight, we could have made that clearer.”
— Evan Siddall

Because it’s always easier to criticize rather than offer a solution, I’m regularly asked what policy makers can do to cool the housing market and my answer is the same. The first and most effective thing they can do is to stop telling Canadians there’s nothing to worry about when it comes to our housing market. Do tell us that our government is concerned about the rapid acceleration in prices and if the market doesn’t cool down naturally, it will introduce policies that aim to cool the market.

This change in narrative alone may be enough to take a considerable amount of heat out of the market while policy makers research and plan potential policy measures.


Keeping an Eye on the Market

Read my full analysis on this and other key trends in the March 2021 Move Smartly Report

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John Pasalis is President of Realosophy Realty, a Toronto real estate brokerage which uses data analysis to advise residential real estate buyers, sellers and investors.

A specialist in real estate data analysis, John’s research focuses on unlocking micro trends in the Greater Toronto Area real estate market. His research has been utilized by the Bank of Canada, the Canadian Mortgage and Housing Corporation (CMHC) and the International Monetary Fund (IMF).

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