Should Canadians concerned about high and rising home prices welcome high gas prices?

Part four of our inflation series

It’s hard to escape the news these days that interest rates are going up in response to pressures from rising inflation.  The most recent Consumer Price Index (CPI) release shows prices increasing at 6.7% annually, the highest since 1991. 

Inflation is concerning not only because higher prices are unpleasant – especially when wages and benefits don’t increase at the same rate.  Rising inflation is also problematic because it tends to invite even more inflation. Expectations of inflation can become a self-fulfilling prophecy. If everyone thinks costs are going to be higher tomorrow, they’ll rush to make purchases today, pushing prices higher. 

The way in which inflation begets more inflation is of great concern to central banks, like The Bank of Canada, whose job it is to prevent prices from spiraling out of control. In a recent press release, Bank officials mentioned as much: “Persistently elevated inflation is increasing the risk that longer-run inflation expectations could drift upwards. The Bank will use its monetary policy tools to return inflation to the 2% target and keep inflation expectations well-anchored.” 

Why is the Bank of Canada only responding to inflation now – when housing prices have been skyrocketing for decades? 

What The Bank of Canada fears for the economy broadly – higher prices becoming self-perpetuating – arguably has already occurred in our overheated housing market. Four decades of rising prices have locked many out of the prospect of home ownership altogether.  And among those who still aspire to purchase a home, the worry is that prices are going to keep rising – so if they don’t get in the market now, they’ll never be able to afford a home. FOMO anyone?

One result is that home buyers are spending as much as they can afford – and often times more – to secure a place for themselves and their families to live. And who can blame them? Rising prices have made housing seem like a fool-proof investment, generating largely tax free wealth windfalls. Many home buyers no doubt expect to reap a strong return by throwing an outsized portion of their earnings and savings into purchasing a home. Plus, rushing to buy before prices rise further is exactly what our economic authorities suggest people will do once inflation expectations get out of hand.

So why have Canada’s financial managers failed to prevent inflation expectations from spiraling out of control in the housing market?

Bad housing price inflation data has led to bad decisions

The Bank of Canada has allowed housing price inflation to run rampant, in part because our central bankers rely on CPI as their primary inflation gauge. But as we’ve described previously, CPI fails to adequately account for skyrocketing property values. To recap, CPI tracks price changes by monitoring a fixed basket of goods. The basket consists of a few main components including transportation, food, clothes – and shelter. The shelter component is meant to represent housing costs, but it does a poor job of this – check out our last blog post to see why. Indeed, completely removing the shelter component from the index only lowers the most recent CPI reading slightly, to 6.5%.  Pretty surprising, given recent double digit housing price inflation!

Overreliance on a broken inflation benchmark has permitted the Bank of Canada to overlook rising home prices in financial and monetary policies decisions that affect Canadian consumers and businesses. Shockingly, the Bank’s most recent statement explaining why they raised interest rates by 0.5% doesn’t even mention home prices in the list of inflation drivers! Instead they focus on energy and food prices, since these have a high impact on the CPI.

Why $2/L gas might be good for home prices

So here’s what we know.  CPI readings are elevated, leading the The Bank of Canada to raise interest rates. These record CPI increases are in large part due to soaring costs for things like food and transportation. Thanks to the CPI’s inability to adequately measure housing price inflation, the runaway housing market isn’t a big part of the Bank’s interest rate decisions.  

Here’s why this is a problem. Once supply chain issues are sorted out and prices for everyday goods moderate, The Bank of Canada will likely go back to claiming that inflation is under control. Continued double digit home price growth still won’t adequately factor into The Bank’s decisions on inflation, because neither the Bank or Statistics Canada are making a move to remedy the weaknesses of the CPI.  The predictable result will be that persistent inflation in what is the major cost of living for most Canadians – housing – will continue to go unchecked by our economic policy levers. 

It may not feel like it, but a silver lining of supply chain issues and commodity prices driving up the cost of everyday goods like gas is that (at least for now) The Bank of Canada has started to make monetary policy decisions that will inadvertently help to cool the housing market. This is good for younger and future generations, and many newcomers to Canada, who can no longer access an affordable place to call home. A 20% increase in the cost of gas may make Canadians spend an extra $50 or $100 (or even more) at the pump. But a 20% increase in the cost of housing adds to hundreds of thousands of dollars to price tags in communities across Canada, crushing the dreams of aspiring homeowners.

Efforts to rein in out of control home values really shouldn’t be a side effect of decisions made to address inflation in other costs of living. We should expect our economic leaders to prioritize Canada’s housing crisis in its own right, and adapt the policy tools available to them to counter the damage caused by high and rising home prices. One easy – and low cost – place to start is developing a new inflation gauge that adequately reflects housing costs for those who aspire to enter the market, not just those who already own homes.