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From: Steve Ambler and Jeremy Kronick

To: The Bank of Canada Governing Council

Date: October 26, 2018

Re:  How Fast Should the Bank Tighten?

This week's Bank of Canada rate increase announcement was widely anticipated. With underlying inflation close to 2 percent and with the economy running at or slightly above capacity, the bank’s overnight rate target appears headed for the rate that would be consistent with steady inflation at full capacity: 2.5 to 3.0 percent.

A key question is how quickly should the bank get to that “neutral” rate?

A closer analysis of the household debt servicing burden shows that rate hikes may appear less worrisome than commonly assumed. Let’s come back to this.

First off, there are no strong signs of higher inflation in the near future. Headline inflation decreased from 2.8 percent in August to 2.2 percent in September, damped by slowdowns in gas and air transportation price increases. The bank’s three measures of core inflation, which are better measures of underlying trends, all edged down by a tenth of a percentage point last month and currently sit close to the 2 percent target.

Perhaps the main reason for caution is the possible impact of rate increases on the financial situations of indebted households. Measures of household debt to GDP and debt to disposable income have been on a steady upward trend and are now at or above 100 percent. However, in a climate where interest rates have trended down for the last quarter century, this is not surprising. Cheaper debt leads to increased demand for it, which leads to higher asset prices. The result is that interest payments on debt have fallen for much of the past 25 years even if the outstanding household debt and principal payments have gone up.

A more telling indicator is the ratio of debt servicing to disposable income, which shows us how much households use out of their monthly disposable income to cover their monthly debt costs. And, with the major exception of the 2005-2007 period that ended abruptly with the financial crisis and recession, debt service ratios have been flat.

What might concern the bank’s Governing Council is the increase to debt service ratios over the last four quarters since the bank started increasing its overnight target rate in July, 2017. If this pattern continues amid further tightening, this could push households to cut back on spending in other areas, leading to a fall in consumption and lower economic activity.

However, looking beyond overall debt service ratios to their underlying components, these fears may not be well grounded. The mortgage debt service ratio, which has driven the recent increase in overall debt service ratios, is only slightly higher today than in 2007. And because it fell dramatically throughout the 1990s and the early years of the millennium before climbing again in 2005-2007, it is still well below where it was at its peak in 1991. And, non-mortgage debt service ratios, while higher now than they were in the 1990s, are comfortably below their peak in 2007.

We also need to distinguish between the debt service loads of households who are taking on new mortgages and those with mortgages coming up for renewal. Housing markets have cooled recently as a result of previous rate hikes, and other regulatory measures such as OSFI’s stress tests on uninsured mortgages. Even in regions where house prices have not fallen, the rate of increase in mortgages is now in many cases below the rate of growth of nominal GDP and personal disposable incomes. This means that the debt servicing burden related to new mortgages may not increase much or at all for these households. Households about to renew their fixed mortgages – still the vast majority of mortgages in Canada – may be facing spikes in their monthly payments. On the other hand, since monthly mortgage payments are fixed in nominal terms while Canadians’ nominal incomes have risen, the debt servicing burden for these households has decreased over the lives of their mortgages.

The dynamics of household debt in Canada are complex. Focusing on debt servicing cuts through some of these complexities, and we are glad to see more analysis of this important measure. This analysis should increasingly focus on the underlying components of debt servicing.

We would encourage the bank to continue to explore these issues as it calculates how quickly to normalize Canadian interest rates.

Steve Ambler is the David Dodge Scholar in Monetary Policy at the C.D. Howe Institute, and professor of economics at the school of management, University of Quebec at Montreal. Jeremy Kronick is Associate Director, Research, at the C.D. Howe Institute.

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The views expressed here are those of the authors. The C.D. Howe Institute does not take corporate positions on policy matters.