Thursday , September 29 2022

End of Year Economic Progress Report: Financial Disputes in Focus



Today, we combine two traditions-one old, new one. The older tradition, which goes back over a decade, sees the Canadian Government Bank talking about the state of our financial system in an end of year speech in Toronto. The new tradition, which started earlier this year, is to offer an Economic Progress Report four times a year, following the publications on interest rates that do not bring up Financial Policy Report (MPR), as yesterday.

My motivation to combine these two traditions is more than just trying to increase productivity. Ten years ago, the global financial crisis gave us the prerequisites for the repetition of the Great Depression in the 1930s. Thanks to aggressive financial and financial policies, we avoided that. But a decade of massive financial stimulus has brought us to a critical period in the economic cycle.

The Canadian economy has been operating close to its capacity for over a year now, unemployment is at its lowest for decades, and inflation is on target. Historically, this is the point in the business cycle where inflationary pressures can start building, so it is natural that we try to move interest rates to a neutral level. At the same time, the decade of extremely low interest rates has led to an increase in home debt, which mainly covers mortgages. And we are all aware of a big increase in house prices in recent years, especially in some of the largest cities.

These financial weaknesses have made a financial policy more complicated. Understanding and integrating to a policy process has been a priority for the Bank. In the meantime, the world has not been standing since our last MPR in October. Indeed, there have been more macro-economic developments than usual. My focus today is, therefore, to bring you up-to-date information and to indicate how financial stability concerns are caught in our decision-making process.

Growth of financial weaknesses

Let me start with a few words about how our financial weaknesses came so big to start. Fact is that debt rises during the recovery period of each economic circle. Low interest rates stimulate recovery by encouraging homes and companies to lend. As a rule, the economic cycle is short enough that the risks caused by this imbalance are relatively small.

Of course, the last 10 years has been far from normal. Interest rates have been extremely low for a very long period. The inevitable result has been a huge demand for housing, rising house prices and a accumulation of household debt from historical shares. The associated connection in financial weaknesses has been a concern to the Bank for several years. Indeed, family debts in Canada rose strongly before the global financial crisis, mainly due to the rules of spreading a mortgage about 15 years ago, financial innovation and interest rates; n degrading.

In response to these developments, the federal government has implemented a series of more restrictive macroscratic policies – designed to ensure that new lending is safer. In particular, with the revised B-20 guideline that came into force earlier this year, all new mortgage loans from federally regulated institutions became subject to some form of stress test to ensure that lenders can handle an increase in rates interest. You can find much more details about this and other stability issues on our Financial System Center on the Bank's website.

Now, I can hear from time by people who say that this stress test should not apply in overlapping housing markets. But the point of the change to B-20 was not to cool housing markets. The point was to increase the resilience of new home debts in the future. Each singer faces the risk of higher interest rates, not just those in hot housing markets.

There is still no doubt that the combination of these stress tests, higher interest rates and housing policies being implemented by provincial and urban governments affect lending in the home. We see far less mortgages being deducted on debt ratios to income above 450 per cent. And credit data shows the growth of mortgage lending slowed this year to a rate of just over 3 percent. At this rate, the total income debt ratio is likely to mean establishing moderate consistency.

In determining financial policy, it is crucial to reject the effects of these different policies. We need to know how much slowdown of credit growth is due to higher interest rates, rather than other policies. How big is the impact of higher interest rates on home spending? And how do different macro-prudent policies, including the B-20 guide, affect the behavior of lenders and home builders?

Obviously, there are no ways of getting detailed answers to these questions. But we need to understand how developments in the financial system affect the real economy and the risks that they face. I talked about this topic almost four years ago during a lecture at the University of the West. I mentioned the idea of ​​developing a grand synthesis – an utopian economic model collecting how the financial system would affect the real and vice versa economy, and will help us to achieve our inflation control mandate.

We may never reach that utopia. But the good news is that we have made significant progress. Let me talk about three important improvements.

Firstly, a new fund developed in the International Monetary Fund growth phase is used by Bank staff now helping to understand the links between the financial sector and the real economy. They capture the increase in financial weaknesses and adverse risks to economic growth associated with them. Accordingly, in considering changing interest rates, we can estimate the normal direct effects on the economy, and the indirect effects through the financial vulnerability channel. The growth framework is not at risk in the prestigious synthesis, but it gives us a more detailed way of thinking about financial weaknesses in our risk management policy framework.

Secondly, we have upgraded our main economic model to include accruing home debts and thus to hold the fact that the economy is more sensitive to interest rate movements when debt levels are high. It also includes the link between debt consolidation and increasing house prices. These are important steps that help to understand the impact of this vulnerability on the economy.

Thirdly, bank staff work with new sources of microdatics to deepen our understanding of how higher interest rates affect mortgage holders. We now have access to unidentified data at the level of individual loan that dates back to 2014, which covers around 85 percent of mortgage loans over this period. This includes information about the size of a mortgage, household income, the interest rate at the beginning, the mortgage term and amortization period.

This data allows us to calculate how higher interest rates affect households through the mortgage renewal cycle. By estimating the effects of higher interest rates on monthly household expenses, we can predict how spending on other purchases will also be affected.

So far, this better framework has performed well to predecessors. However, it is important to remember, to date, that most homes have been renewing mortgage rates that are quite similar to the rates they have joined for five years ago . As we move on, people will face higher interest rates increasingly when they renew, and we will learn more about how people adapt.

It is clear that many families who are very owed will face a difficult adjustment as mortgages are reinstated and interest rates rise. Still, these adjustments will be much less difficult than there were serious negative economic shock, especially if financial weaknesses could continue to grow unchecked.

Now, the fact that household spending behaves broadly as expected is giving us more confidence that we understand what is happening in the economy. But lenders and lenders continue to adjust to raise interest rates and new mortgage rules. So, we closely watch a number of trends in mortgage markets. For example, the proportion of mortgages that arise outside federal jurisdiction, including private lenders and credit unions, increase. These lenders are not subject to a formal interest rate stress strain test. There has been an increase in the proportion of mortgages granted by private lenders in the Toronto area, although we do not have this type of data for cities outside Ontario.

We have also seen a larger proportion of lenders who are very owed taking variable rate mortgages. In doing so, they reduce their debt service burdens because, usually, the interest rate on a variable rate mortgage is lower than on a fixed rate mortgage. This lends money for spending or saving in the short term, but it does not reveal the unexpected increase in interest rates down the road. Having said that, the stress test in our place gives us the confidence that these lenders can manage significantly higher payments, if necessary.

In summary, although the quality of the new lending has improved, the stock of dangerous mortgages remains high. Over time, those mortgages should become less dangerous as they are paid gradually. But this vulnerability will continue for many years.

Developments in housing markets are very close to the increase in household debt. Everyone is talking about this issue – it's not surprising when you see that house prices in the Toronto area are nearly 40 percent higher than they were three years ago. In the Vancouver area, the progress has been even more – around 50 percent. Outside both areas, the average home price has increased by only 5 per cent over the three year period.

In order to be clear, basic factors have pushed house prices in Toronto and Vancouver. A strong population and employment growth have a supported housing call. The cost of a number of inputs, such as construction labor and development fees, has also increased. At the same time, different policies and other factors have limited supply growth in both places. If the supply does not expand in a strong demand climate, you have a recipe at prices that arise.

Having said that, it was clear to us that the rise in prices was swellowed by speculative activity, especially during 2016-17. Some buyers accelerated their purchases, motivated by fear that they would be priced out of the market if they were waiting. Others, mainly investors, bought real estate on the assumption that prices would continue to rise. This is significant, because when speculative activity is driving prices higher, economic shock can encourage a sharp decline. Anyone who remembers the housing market in the early 1990's in Toronto and Vancouver will recognize this point. And the effect of such a reduction is inflated when the owners of the houses are very owed.

The Bank has raised the five-hour policy interest rate over the last and a half year, with a total of 125 basic points. And I have heard from some Canadians, more recently, who are concerned about the impact of these rates on housing affordability. However, given the combined impact of provincial and urban housing measures and tightening macro-economic policies – not to mention higher interest rates, housing prices to Canada in general are now growing at an annual rate of around 2 per cent. It seems to me that this reduction in house price inflation is much more meaningful in terms of affordability for first-time buyers or the interest rate movements we have seen. The basic laws of economics tell you that the measures to increase supply would be the most effective way of supporting affordability. And that increases demand, with no corresponding increase in supply, could make affordable housing worse.

Speaking about the rise in interest rates, a risk associated with the Canadian financial stability that we have been watching is close to global interest rates. As Canada would normally import about 60 to 70 percent of any increase in a global bond product, we would see the corresponding effects on our mortgage rates, even if the Bank rate of Canadian Bank did not take place. This risk remains vigorous, especially bond bondage and equity market in recent weeks. Most observers would argue that the emerging inflation from the US would be the likely catalyst for such a risk, and & That likelihood has risen with the US economy response to a fiscal stimulus. However, our prospects continue that the US economy will moderate to more sustainable speeds next year and to 2020 and that inflation expectations continue anchor.

So let's summarize the financial stability position. The Governing Council judges that the overall level of risk to the Canadian financial system is the same as it has been six months ago, when we published our Review of Financial System. New mortgage lending is more robust, and the growth of house prices has interrupted. However, the stock of home debts will remain high for years, and house prices continue to be higher in some markets. Our new growing and emerging framework clearly shows that macroscratic policies have worked to mitigate the risk of financial stability, thereby improving the risk management risk facing financial policy.

Macroeconomic risks and inflation forecasts

Let me turn to the macroeconomic. As we said in October, the economy has been operating almost for more than a year and inflation is on target. Since October, there have been a number of important developments.

First, there have been growing concerns of global economic slowdown. We will note that our prospects are already calling for economic growth moderation in 2019-20, but this would only bring us into a sustainable growth track and would not cause concern. However, the main risk that we see today's forecast is continuing trade tensions between the United States and other countries, especially China.

Increasing tariffs will slow down economic growth and reduce productivity on both sides, and will raise the risks of inflation other than – a combination that we used to call stagflation. This combination is particularly challenging for financial policy, as it imposes a ban between the fall of economic growth through lower interest rates and which includes a risk of inflation with higher interest rates. Because the effects on the economy would be likely to be structural, rather than cyclical, I must believe that inflationary risks would become crucial in total trade war.

Importantly, the risks around global trade are both sides. Yes, there is growing evidence that trade actions already have negative macroeconomic effects. But as central bankers we can not only focus on the worst situation. The underlying risk is that the US and China come to terms, and the global economy enjoys a new lift source. The events last weekend in Buenos Aires were rather encouraging at this front. Therefore, we continue to weigh on both sides of the issue.

In terms of the Canadian economy, it is fair to say that the data released since our October MPR has been on the disappointing side. Although the GDP data for the third quarter was close to our expectations in general, there was no basic constitution of growth, and less economic momentum went into the fourth quarter than we were in believe it would.

Although recent data from the housing sector has been softer than expected, we believe that this is the result of a significant adjustment in new builds of single dwellings to multiples, and this conversion has extended the slowdown in housing construction that started earlier this year. Population growth and employment, and therefore the basic demand for housing, remain strong. Credit growth has also been consistent, all of which supports our view that the market stabilizes.

Business investment was unexpectedly reversed in the third quarter. We had indicated earlier this year the likelihood of uncertainty about the future of NAFTA would hold back investment decisions. It is now apparent that this effect is very strong during the summer, when it was uncertainty at its peak. The other business investment that prevented major factors was the delay in the Trans Mountain Pipeline project.

CUSMA signs are likely to support a refund in investment, especially given continuous capacity constraints, although governments still need to implement the contract. Moreover, recently announced federal government tax changes will lead to further strengthening in investment. This would also suggest continued growth in exports, which was supported by a strong foreign demand, but limited by tight capacity.

Releasing the latest GDP, Canada Statistics reformed its historical estimates of economic growth. Most of these reforms relate to shifts in the economic structure starting in 2015, as the economy adapts to a steep reduction in oil prices. It may seem strange that developments in 2015 could affect our economic opinion in 2018, but they can do it. The GDP level is now believed to be almost 1 per cent lower than previously thought. The effect of this review on the inflation forecasts will depend on the amount of that shift needed and the amount in economic supply or capacity, and therefore how our estimates of the gap between the two are affected. We will say more about this in our January MPR, once our analysis has finished.

Much of the Governing Council's debate focused on oil. Global oil prices are far lower than anticipated assumptions in our October MPR, mainly due to supply forces. There is also an important cover of concern about the moderation of global economic growth, given higher trade tensions, with implications for the demand for oil in the future.

The main source of extra oil supply is the same as it was back in 2014: the United States. To refer to it, the world uses around 100 million barrels of oil per day. Back in 2008, the US production was about 7 million barrels a day. By 2014, the revolution of the chalet had pushed that figure up to 12 million. Today, US production is more than 15 million barrels a day, more than twice the 2008 level. That's 2 million more than just a year ago, and US oil exports have risen & One amount over that time.

These developments in the United States produce the production of Canada – we produce about 5 million barrels a day and export just over 3 million. The weak global oil prices have a direct impact on Canada, as we know from experience in 2015-17. This affects all producers, in the east and west. Although the Canadian economy has generally completed its adjustment to lower oil prices by mid-2017, adjustments to cost structures, and for salaries and employment in oil production regions, have continued. Indeed, the proportion of oil and gas production in the Canadian economy has decreased since 2014, from about 6 per cent to about 3½ percent today.

The recent decline in oil prices in the world has been expanded in West Canada, as the decline in heavy oil, Western Canada Select, has expanded into a record. This is mainly due to transport restrictions, but it was complicated this autumn by closing to maintenance in some key US refineries. Since our decision on October rate, the heavy oil fall has fallen slightly since US refineries have come back online. However, in recent weeks, the decline has also spread the price for western Canada crude oil, Edmonton Par, as the storage list has reached recording levels. The Alberta initiative to install input reductions and adding more rail capacity will help clear up the backlog, and more capacity would be of long term support.

Although we did not prepare completely new economic forecasts for a decision yesterday, we will do that between now and next decision in January. It is already clear that a painful adjustment is developing for West Canada, and there will be a meaningful effect on the Canadian macro-economy. Having said that, given the consolidation of the energy sector since 2014, the net effects of lower oil prices on the Canadian economy in general, dollar for the dollar should be less than in 2015.

Summing up then, as I said, many have happened since our October MPR. But do not forget that these developments have come against the low-unemployment rate background and 40 year inflation close to the target, consistent with an economy that has been operating close to its ability. We will assess all of these new developments in our new projections in January MPR.

The Government Council decided yesterday that the current level of interest rates remained appropriate for the time being. And, weighing all these developments, we continue to judge that the policy interest rate will need to increase to a neutral-range range in the locality from 2.5 to 3.5 percent-in order to reach the inflation target . The speed that this process takes place, of course, will continue to be determined in terms of data depending. We will continue to measure the impact of higher interest rates on use and housing, and monitor the development of global trade policy. The persistence of the oil price shock, the evolution of business investment and the economic capability will also be an important factor in our decisions regarding the future financial policy perspective.


I'm just coming to the conclusion. I hope that my speech will show you how financial weaknesses are in line with financial policy discussions. We have made progress in thinking about these and other weaknesses and understanding the risks that they face to the economy. I have also tried to give you the sense of the many issues that we are striving with in managing the macroeconomic risks that face the Canadian economy. We will continue to manage these risks as we follow our mandate to control inflation and promote the economic and financial wellbeing of Canadians.

I wish every season of happy happiness and every one of the best in the new year.

I would like to thank Don Coletti for his help in preparing this speech.

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