EconoFACTS

June 09, 2022 | 12:03

BOC FSR—Nothing Here to Derail Aggressive Rate Hikes

Economist

Managing Director, Canadian Rates & Macro Strategist
Fixed Income Strategy

Benjamin has been with the Bank of Montreal for over a decade. He is responsible for the Canadian macro-economic... (Read more)

Shelly Kaushik

Economist
Economics

Shelly joined BMO Economics in 2020 and conducts research on U.S. regional economies. She also provides support ... (Read more)

Benjamin Reitzes

Managing Director, Canadian Rates & Macro Strategist
Fixed Income Strategy

Benjamin has been with the Bank of Montreal for over a decade. He is responsible for the Canadian macro-economic... (Read more)

Shelly Kaushik

Economist
Economics

Shelly joined BMO Economics in 2020 and conducts research on U.S. regional economies. She also provides support ... (Read more)

The Bank of Canada’s Financial System Review presented six key vulnerabilities for 2022:

Elevated levels of household debt
Elevated house prices
Business reliance on high-yield debt markets
High potential demand for market liquidity, relative to supply
Cyber threats
Mispricing of assets that are exposed to climate risks

The first two risks are potentially the most impactful for the near-term path of monetary policy. And, they are connected as the red-hot housing market has pushed up demand for mortgage loans. While rising home prices have increased the homeowner equity available for many households, those that bought a home in recent quarters are more vulnerable to rising interest rates. To highlight that point, the report estimates that the share of highly indebted households rose above its pre-pandemic peak in 2021. Over half of Canadian homeowners have a mortgage—70% have a fixed-rate mortgage, with the balance sporting a variable rate. Amid aggressive policy tightening, the Bank is concerned that rising debt-service costs could force households to “significantly reduce their consumption”. Despite the concerning debt trends, the FSR also highlights that household balance sheets have generally improved through the pandemic. Higher asset prices and increased savings are helping households on average, though those with high debt ratios have benefitted less from those factors.

At the same time, we’re already starting to see signs of cooling in the housing market. While that helps to address Vulnerability #2, it weighs on homeowners’ assets and limits their ability to borrow against their home equity, particularly for recent buyers that have not benefitted as much (or at all) from rising prices. The Bank believes it's too early to make a judgement on the direction for housing activity and prices. However, an expected string of 50 bp (or perhaps larger) rate hikes points squarely to ongoing weakness in housing generally. The BoC is rightly concerned about the potential for "extrapolative expectations" to manifest on the downside in the same way we saw expectations feed higher prices in recent years.

The other four major vulnerabilities noted by the BoC should not be brushed aside, but aren't likely to have a near-term impact. The health of corporate balance sheets has improved overall, suggesting less risk from rising interest rates. That shouldn't be a surprise as most sectors in the economy are performing well, and growth has been robust. Market liquidity is an ongoing issue, and has been a consistent feature of recent FSRs. Similarly, cyber threats and exposure to climate risk are issues highlighted in the past though the war in Ukraine has driven heightened cyber worries.

What does this mean for monetary policy? The overriding message was consistent with the latest policy statement and Deputy Governor Beaudry's speech. Governor Macklem stressed that "the Bank’s number one priority is to get inflation back to target". While household debt and housing are a concern for policymakers, inflation is driving the policy bus for now. That focus will likely come under increasing stress in the coming months as policy rates are pushed consistently higher. There's nothing in this FSR to suggest the BoC will back off its aggressive policy stance. We continue to anticipate 50 bp rate hikes in each of the next three policy meetings, bringing overnight rates up to 3%.