Let’s stop pretending that interest rates don’t affect home prices

The Canadian housing market recently experienced its most significant price drop on record. According to the MLS HPI Composite Benchmark, prices are down $133,300, or 15%, over the last year across the country. 

This slowdown followed years of relentless growth in home prices, a trend that really got out of hand during the pandemic. There were single months when prices rose by 5%. At that time it was hard to imagine that anything would ever be able to slow the red-hot market. 

That is, unless you were following Generation Squeeze. 

Canadian home prices

We’ve been arguing for years that monetary policy plays a role in determining property values.  Our research identifies low-interest rates as a contributing force driving the run-up in home prices. So we were not surprised to see the market cool off when The Bank of Canada increased interest rates, undermining the cheap credit system that helped buyers bid up home prices.

The Bank of Canada managed to do the unthinkable - cool off one of the world's hottest housing markets - by raising interest rates. So why do they rarely ever mention this?

The cost of purchasing a home isn’t mentioned anywhere in their most recent monetary policy decision statement or the 36-page monetary policy report. These documents do mention mortgage interest costs, and how they have risen along with interest rates – creating economic pressures for some Canadians. They note that activity in the housing market has slowed, specifically in terms of the number of sales, and how this impacts economic growth. But nowhere do they comment on home prices directly.

Weird isn’t it? Home prices affect each of our lives in one way or another. You would expect an organization like the Bank of Canada that makes decisions capable of impacting home prices so significantly to at least recognize what they’ve done.

The decision not to mention home prices might be less surprising once you consider that The Bank of Canada did not set out to curb rising home prices. The rate hikes implemented over the last year were prompted by increases in the cost of everyday goods like fuel and food, not skyrocketing home prices. The housing market slowdown was an accidental side effect of efforts to deal with the rising cost of day-to-day purchases.

The Bank of Canada’s job is to keep inflation low and stable. In Canada, the Consumer Price Index (CPI) is synonymous with inflation – but as we’ve made clear in previous articles, CPI doesn’t adequately account for home prices. Perhaps that explains why The Bank of Canada also fails to acknowledge them. Relying on CPI to measure inflation blinds The Bank to changes in home prices, the largest purchase Canadians make.

The use of CPI to measure inflation has not only caused problems for The Bank of Canada. It has also blinded the rest of us to how rising home prices have damaged our purchasing power. Recent high CPI readings have empowered workers to ask for raises because their earnings aren’t keeping up with the prices they pay. For example, the Public Service Alliance of Canada (PSAC) has argued that “increased wages to keep up with inflation is the union's top concern”.

But workers didn’t just start having their purchasing power eroded by post-pandemic rising prices. For years, Canadians have been steadily losing purchasing power due to rising home prices – far more than they lost in the last year due to rising food and fuel prices. But our inflation measure covered this up. 

A better inflation measure could have made clear long ago that purchasing power was being eroded by the escalation of housing costs, perhaps providing economic decision-makers with greater motivation to act sooner, and more boldly, to protect affordability. Instead, we’ve allowed wages to decouple from home prices: the average time to save up a 20% downpayment grew from 5 years in 1976 to 17 years in 2022.

It’s time to stop pretending that rising home prices don’t contribute to inflation and that monetary policy doesn’t affect property values. Our reliance on CPI to measure inflation enables these oversights. We need the federal government to mandate Statistics Canada to design a better inflation measure so we are equipped to address housing price escalation head-on, not as a byproduct of other economic trends.

Kareem Kudus is a Gen Squeeze Director and Research Analyst. While working in the finance industry, he realized that our economic system is both less efficient and less fair than it has the potential to be, oftentimes due to well-meaning policies with unintended consequences. He left finance to study artificial intelligence and its applications to the medical field. He's now using the knowledge he gained in his finance career to help Gen Squeeze find solutions to Canada's economic issues.