Bank of Canada’s increasingly hawkish tone on inflation could potentially dent home sales, Capital Economics says

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According to a report by an economist from Capital Economics, Canada could be at risk of a recession induced by a rapid correction in the housing market if the Bank of Canada becomes too aggressive with its rate hikes.

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In a Tuesday update, Canada’s Chief Economist Stephen Brown noted that the central bank did not appear scared by a double-digit drop in home sales in May – the second consecutive monthly decline – and that it was adopting an increasingly belligerent tone on inflation.

“This raises the odds that the bank will make a bigger interest rate hike at its July meeting and raises concerns that it is taking a more aggressive approach to policy tightening than is ultimately needed, leading to a sharp drop in house prices and risking a major recession,” he said.

National home sales fell 12% month over month in May, after falling 14% in April. While Brown suggested the declines would bring sales closer to the pre-pandemic norm, the balance between supply and demand gave him more reason to worry.

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Additionally, the firm’s data revealed that falling sales-to-new listings ratios in major markets like Toronto, Montreal, Vancouver and Calgary imply that home price inflation could drop from 18% in April to zero. by the end of the year.

Home prices are already down, according to data from Capital Economics, slipping 0.6% month-over-month across the country. Toronto saw prices fall even faster by more than 3% for the second consecutive month in May.

Brown noted that the Canadian housing sector featured little in the bank’s policy statement accompanying its decision to raise interest rates by 50 basis points on June 1, stating only that “the Housing market activity is moderating from exceptionally high levels.”

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The bank will release its 2022 financial system review on June 9, where it may go into more detail on the moderation in the housing market.

As inflation hits multi-decade highs — Canada’s price index jumped 6.8% in April — the bank has signaled it’s ready to crack down on rising consumer prices with hikes higher rates. Bank of Canada Governor Tiff Macklem hinted in April that the central bank might temporarily move the overnight rate above the neutral 2-3% range, which would not help either would hamper economic growth.

Deputy Governor Paul Beaudry echoed that sentiment in a June 2 speech the day after the latest key rate decision, saying the bank should raise its benchmark interest rate to at least 3% to rein in the ‘inflation.

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However, Brown argued the danger is that the bank will misunderstand the impact of its aggressive policy tightening and potentially dent home sales.

“If the bank raised its key rate to 3.5% … then the housing market would face the most dramatic hit to affordability since the Volcker shock of the early 1980s,” Brown said, referring to the period when Federal Reserve Chairman Paul Volcker aggressively hiked rates.

Brown added that according to his company’s estimates, a key rate of 3.5% would bring the average five-year fixed rate mortgage rate to 4.5% and the average variable rate to 4.9%. Despite accelerating wage growth this year, Capital Economics estimates that these mortgage rates would reduce the maximum home price buyers could afford by 23%, which Brown said would have an impact four times greater than the three previous tightening cycles.

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