The bad news is that inflation will likely remain too high for some time. Many of the global factors that have pushed up inflation won’t go away quickly enough — supply chain disruptions continue, geopolitical tensions are high, and commodity prices remain volatile. And here at home, our economy has been running too hot. As Canadians finally enjoy a fully reopened economy, they want to buy more goods and services than our economy can produce. Businesses are having trouble keeping up with demand, and that’s leading to delays and higher prices. The result is broad-based inflation. Even if inflation came down a little in July, prices for more than half of the goods and services that make up the CPI basket are rising faster than five per cent.

As the central bank, it’s our job to control inflation and that means we need to cool things down. That’s why we have been raising interest rates since March. In July, we took the unusual step of raising the policy interest rate by a full percentage point, to 2.5 per cent. Increasing our policy rate raises borrowing costs across the economy — for things like personal loans, car loans, and mortgages. And when we increase the cost of borrowing, consumers tend to borrow and spend less and save more. We need to slow down spending to allow supply time to catch up with demand and take the steam out of inflation.

One area of the economy where it is easy to see how this works is the housing market. With higher mortgage costs, housing activity has slowed quickly after unsustainable growth during the pandemic, and housing prices are moderating. As housing slows, peoples’ spending on housing-related goods and services, such as renovations and appliances and furniture, should also slow.

To tame inflation, we need to bring overall demand in the economy into better balance with supply. Our goal is to cool the economy enough to get inflation back to the two per cent target. We don’t want to choke off demand — we want to slow its growth. That’s what we call a soft landing. By acting forcefully in raising interest rates now, we are trying to avoid the need for even higher interest rates and a sharper slowing down the road.

I know some Canadians are asking, “Why are you raising the cost of borrowing when the cost of everything is already too high?”

We recognize that for many Canadians higher interest rates will add to the difficulties they are already facing with high inflation. But it’s by raising borrowing costs in the short term that we will bring inflation down for the long term. This will ultimately be better for everyone because high inflation hurts us all. It eats away at our purchasing power and makes it difficult to plan our spending and saving decisions. It feels unfair and that erodes confidence in our economy.

The best way to protect people from high inflation is to eliminate it. That’s our job, and we are determined to do it. Tuesday’s inflation number offers a bit of relief, but unfortunately, it will take some time before inflation is back to normal. We know our job is not done yet — it won’t be done until inflation gets back to the two per cent target.

Tiff Macklem is governor of the Bank of Canada

I published Macklem’s statement in its entirety to do it justice. You can decide whether you think the overnight rate will go up by 50 vs 75 bps on September 7th, but undoubtedly it will go up. It is also clear that the Bank will not cut the policy rate until inflation is at the 2% target. So don’t assume that variable mortgage rates will decline quickly in response to a slowdown in the economy. The Bank’s emphasis on the housing slowdown being an essential precursor to the reduction in overall economic activity portends an extended period of credit stringency.

This is a sea change in the economy. This is the end of a forty-year bull market in bonds triggered by the disinflationary forces of globalization, cheap emerging market labour and rapid technological advance. It is also the end of very cheap credit. Household balance sheets will feel the pinch. Recent home borrowers who benefited from the record-low mortgage rates for the two years beginning in March 2020 will increasingly feel the constraint of higher borrowing costs on their discretionary spending. Ultimately, this will return inflation to its 2% target, but it will take a while.

The Consumer Price Index (CPI) rose 7.6% in July from a year earlier, compared to 8.1% in June. The dip reflected the largest drop in gasoline prices since the pandemic’s beginning.

On a monthly basis, however, inflation increased 0.1% from the June reading, the seventh consecutive rise. Excluding gasoline, prices rose 6.6% y/y last month, following a 6.5% increase in June, as upward pressure on prices remained broadly based.Consumers paid 9.2% less for gasoline in July compared with the previous month, the largest monthly decline since April 2020. Ongoing concerns related to a slowing global economy, as well as increased COVID-19 pandemic public health restrictions in China and slowing demand for gasoline in the United States, led to lower worldwide demand for crude oil, putting downward pressure on prices at the pump.

On a monthly basis, gasoline prices fell the most in Ontario (-12.2%), where the provincial government temporarily lowered the gasoline tax.

On a year-over-year basis, the mortgage interest cost index (+1.7%) increased for the first time since September 2020 amid elevated bond yields and a higher interest rate environment.

Year over year, growth in other owned accommodation expenses (+9.7%) and homeowners’ replacement cost (+9.1%) slowed, reflecting current trends in many regional housing markets across Canada.

In the context of higher mortgage rates, which could lead to additional rental demand, rent increased 4.9% in July compared with the same month in 2021, following a 4.3% increase in June. Faster price growth in the rent index was largely driven by an acceleration in Ontario (+6.4%) and Alberta (+3.4%).

With some luck, price pressures might be peaking. The chart above shows the Bank of Canada’s most recent forecast for inflation. The Bank of Canada estimated inflation would average about 8% through the third quarter of 2022 before slowing. Now, the estimate could be revised a bit lower this time. That is why roughly half of the market participants expect a 50-bps rate hike next month, revised down from the 75-bps figure widely expected a month ago. Either way, the prime rate is rising more rapidly than the five-year government of Canada bond yield, making fixed mortgage rates relatively more attractive than variable rates tied to prime. Regardless of which path the Bank takes at the next meeting, the Bank will stay the course for some time.

Central banks cannot return to easy money quickly without risking another burst of inflation. Even with the Canadian economy slowing sharply in the second half of this year, labour markets remain very tight, and the central Bank is behind the curve. With hindsight, we know they kept rates too low for too long, triggering excess demand, particularly in the red-hot housing sector. Watching that unwind, especially in the country’s most expensive and frothy housing markets, will be the Bank’s most prudent option.

The actual (not seasonally adjusted) number of transactions in July 2022 came in 29.3% below that same month last year.

Housing market analysts at the Canadian banks continued to revise their home price forecasts over the next year. Royal Bank, TD, Desjardin and BMO all project that Canadian benchmark prices will fall roughly 20%-to-25% from their February peak by the end of 2023. Of course, this will vary from region to region. The hardest hit has been the geographies where prices surged the most, especially in the Greater Golden Horseshoe in Ontario and, to a lesser extent, in BC.

However, even if these forecasts prove to be correct, home prices in most regions will remain well above the levels posted before the pandemic began in early 2020. Housing in Canada’s largest cities will remain unaffordable for median-income households.

The number of newly listed homes fell back by 5.3% month-over-month in July. The decline in new supply was broad-based, with listings decreasing in about three-quarters of local markets, including most significant markets.

With sales and new listings down by 5.3% in July, the sales-to-new listings ratio remained unchanged at 51.7% – slightly below the long-term average for the national sales-to-new listings ratio of 55.1%.

There were 3.4 months of inventory on a national basis at the end of July 2022, still historically low but up quite a bit from the all-time low of 1.7 months set at the beginning of 2022.

Regionally, most of the monthly declines in recent months have been in markets across Ontario and, to a lesser extent, in British Columbia.

Prices continue to be more or less flat across the Prairies while only now showing minor signs of dipping in Quebec. On the East Coast, prices continue to rise at a much slower pace. The exception is relatively more expensive Halifax-Dartmouth, where prices have dipped slightly.

The non-seasonally adjusted Aggregate Composite MLS® HPI was still up by 10.9% on a year-over-year basis in July. However, those year-over-year comparisons have been winding down quickly from the near-30% record year-over-year increases logged in January and February.

The Bank of Canada raised the overnight policy rate by a percentage point on July 13, so the full effect of this jumbo hike will likely spill into the August data. Inflation fell a bit more than expected last month in the US. We expect to see a decline in Canadian CPI inflation in July, as well, when it is published tomorrow morning. Nevertheless, central banks will continue to tighten monetary policy further. CREA today said they expect an additional 100 bp hike in the remainder of this year, which would take the policy rate up to 3.5% by yearend. That would imply a prime rate of 5.7%.

In contrast, the five-year government of Canada bond yield is hovering just under 2.8%, reflective of the economic slowdown in Canada in the second half of this year. This could make fixed mortgage rates more attractive to future borrowers. Should the prime rate hit those levels, many fixed-payment variable rate borrowers that first booked their mortgages when prime touched 2.45%–it’s low posted since mid-March 2020– might be hearing from their lenders regarding potential trigger points. Will this temper Bank of Canada rate hikes?

Probably not. The Governing Council makes its next decision on September 7. Another 50-to-75 bps is baked in at this point.

Travel-related prices declined last month. The index for airline fares fell sharply in July, decreasing 7.8%. Hotel prices continued to drop, falling 2.7% on the heels of a similar decrease in June. Rental car prices fell as well from historical highs earlier this cycle.

Bottom Line

The expectation is that the softening in inflation will give the Fed some breathing room. Fed officials have said they want to see months of evidence that prices are cooling, especially in the core gauge. They’ll have another round of monthly CPI and jobs reports before their next policy meeting on Sept. 20-21.

Treasury yields slid across the curve on the news this morning while the S&P 500 was higher and the US dollar plunged. Traders now see a 50-basis-point increase next month as more likely than 75. Next Tuesday, August 16, the July CPI will be released in Canada. If the data show a dip in Canadian inflation, as I expect, that could open the door for a 50 bps rise (rather than 75 bps) in the Bank of Canada rate when they meet again on September 7. That is particularly important because, with one more policy rate hike, we are on the precipice of hitting trigger points for fixed payment variable rate mortgages booked since March 2020, when the prime rate was only 2.45%. The lower the rate hike, the fewer the number of mortgages falling into that category.

On a monthly basis, the CPI rose 0.7% in June, following a 1.4% increase in May. On a seasonally adjusted monthly basis, the CPI was up 0.6%.

On average, prices rose faster than hourly wages, which increased 5.2% from 12 months to June, based on the Labour Force Survey data.

Gasoline prices are highly visible and have surged a whopping 54.6% y/y. That compares to a 48% increase in May. There might be some reprieve in this component of inflation, as gas prices largely follow crude oil prices, which peaked in early June and have trended downward so far in July. This would be welcome news for the Bank of Canada.

All central banks worldwide (except Japan) face much more than expected inflation. The rise in the annual pace of inflation past the 8% mark will keep the Bank of Canada on its tightening path, though the numbers show some evidence of softening. For example, food prices appear to be easing, and gasoline price inflation may have peaked. Food prices were up 0.1% in June, the slowest increase in a year. Shelter costs gained 0.4%, the smallest increase since November. Statistics Canada said that reflects lower real estate commissions as the housing market slowed.

With some luck, price pressures might be peaking. The chart below shows the Bank of Canada’s most recent forecast for inflation published last week in the July Monetary Policy Report. The Bank of Canada estimated inflation would average about 8% through the third quarter of 2022 before slowing.

According to the swaps market, traders are betting that the central Bank will hike its policy interest rate another 75 basis points on September 7 when it meets again, after the full percentage point increase last week. That would take the overnight rate from 2.5% current to 3.25%–above the Bank’s estimate of the neutral range. It would also push up the prime rate from 4.7% to 5.45%, leading to a 75 bps hike in variable rate mortgages. Last week’s action already took variable mortgage rates to roughly 4.25%, which increased the qualifying rate on such loans to 6.25%–above the 5.25% rate before the move. As a result, the gap between the qualifying rate for fixed-rate mortgage loans and variable-rate loans has fallen to only about 100 bps, its lowest level in years. This undoubtedly continues to slow housing activity, reducing economic growth in Canada.

The question remains–will the Bank of Canada successfully reduce inflation without triggering a recession? Stay tuned.

“Sales activity continues to slow in the face of rising interest rates and uncertainty,” said Jill Oudil, Chair of CREA. “The cost of borrowing has overtaken supply as the dominant factor affecting housing markets at the moment, but the supply issue has not gone away.”

The Bank of Canada’s shocking 100 basis point hike in the benchmark policy rate will accelerate the slowdown in the coming months. 

“One important feature of the market right now that isn’t getting enough attention is the difference in mortgage qualification criteria between fixed and variable, because while variable rates adjust in real-time, fixed rates have already priced in most of what the Bank of Canada is expected to do over the balance of 2022,” said Shaun Cathcart, CREA’s Senior Economist. “As such, it’s no surprise to see people piling into variable rate mortgages at record levels, but probably not for the reasons they may have chosen them in the past. It’s because the 200 basis points plus the contract rate element of the stress test has, just since April, become much more difficult to pass if you want a fixed-rate mortgage. A strict stress test made sense when rates were at a record-low, but policymakers may want to assess if it continues to meet its policy objectives now that fixed mortgage rates are back at more normal levels.”

The number of newly listed homes climbed 4.1% month-over-month in June. The monthly increase was most influenced by a jump in new supply in Montreal, while new listings in the GTA and Greater Vancouver posted slight declines.

With sales down and new listings up in June, the sales-to-new listings ratio eased back to 51.7% – its lowest level since January 2015. It was also below the long-term average for the national sales-to-new listings ratio of 55.1%. Almost three-quarters of local markets were balanced markets based on the sales-to-new listings ratio being between one standard deviation above or below the long-term average in June 2022.
There were 3.1 months of inventory on a national basis at the end of June 2022, still historically low but slowly increasing from the tightest conditions recorded just six months ago. The long-term average for this measure is more than five months.

The Aggregate Composite MLS® Home Price Index (HPI) edged down 1.9% on a month-over-month basis in June 2022.

Regionally, most of the monthly declines were seen in markets in Ontario. Home prices have also eased in parts of British Columbia, although the B.C. provincial totals have been propped up by mostly static prices in Greater Vancouver.

Prices continue to be more or less flat across the Prairies while only just now showing small signs of declines in Quebec.

On the East Coast, prices are mostly continuing to rise but appear to have stalled in Halifax-Dartmouth.

The non-seasonally adjusted Aggregate Composite MLS® HPI was still up by 14.9% on a year-over-year basis in June, although this was just half the near 30% record year-over-year increases logged in January and February (see chart and tables below for details by region).

In many respects, today’s housing data trends are already outdated. It changed with the blockbuster rate hike a couple of days ago. Excess housing demand is essentially over, and we are heading into a more fragile period for resale volumes and prices. The national sales-to-new listings ratio fell to 51.7% in June, which is considered balanced, but it’s the lowest ratio since 2015 and is headed in a softer direction. Buyers’ markets are already evident, especially in some of the suburbs/exurbs in Ontario and parts of BC. These are the regions that posted extreme price gains last year. Others, such as cities in oil-rich Alberta and Atlantic Canada, are still holding in well.

With the Bank of Canada’s most recent tightening, qualifying rates are ratcheting up for both variable and fixed mortgage rates. Before the one percentage point rate hike, variable rate loans were qualifying at 5.25%, but now that has shifted to around 6%. Fixed-rate borrowers are qualifying at about 7%. The Canadian prime rate has surged this year, increasing variable mortgage rates by roughly 300 basis points. Robert Kavcic at BMO has calculated that “going from 1.5% to 4.5% on the same loan value would crank up the monthly variable-rate mortgage payment by almost 40%, making the current episode an even more abrupt shift than the late-1980s  after adjusting for income levels.”

Kavcic continues, “the vast majority of borrowers currently on variable-rate mortgages have fixed payment features, but even there, things are now getting dicey. For example, moving a variable rate up from 1.5% to 4% with a fixed payment would effectively increase the amortization from 25 years to 45 years. Another 50 basis-point rate hike in September would take that above 60 years—that is, many will reach the point where payments are no longer taking down the principal. Each mortgage will have its unique terms when payments start to move higher, but for those that caught the low in variable rates, we’ll probably be there soon. Of course, HELOC payments used to finance many multiple-property purchases are ratcheting up in real time.”

There is also the risk that the federal financial institutions’ regulator, OSFI, will intervene to protect the big Chartered Banks from taking on too much risk rather than making it easier for borrowers to qualify or to carry variable-rate loans in this environment.

Moreover, mortgage renewals pose a problem as well. Fixed mortgage rates five years ago were roughly 3%. Resetting the mortgage at 4.5% will lead to a monthly payment increase of approximately 15%, all else equal.

With the latest move by the Bank of Canada, more potential buyers will believe that home prices are likely to fall, taking the FOMO factor out of the housing market. This removes the critical ingredient that drove prices up rapidly since the pandemic began.