The rate cuts of early 2001 were an effective central bank policy and were working to spur consumer demand, but the black swan event of September 11, 2001 changed the economic paradigm. To address the major economic impact of the terrorist attack, the Federal Reserve continued a policy of lowering interest rates. This policy was important: after 9/11 the United States invaded Afghanistan, in March 2003 it invaded Iraq. The combined cost of these wars was immense, and the Republican-led Congress determined that the economic recovery could not be sustained with tax increases - thus a period of deficit financing began.
Debt-financed wars are not uncommon, but with deficits entering the hundreds of billions, the Federal Reserve had to act to ensure that interest payments on the debt would not be crippling to the US federal budget.
As a result of this massive increase in public indebtedness, the Federal Reserve under Greenspan continued to cut interest rates to assist in financing the tax cuts and wars. This is standard central bank policy dating back to World War I. The interest payments on a low interest rate vs. a nominal interest rate can save billions for the government.
Unintended Consequences
This policy, while prudent, created "externalities". This low rate environment that the Fed perpetuated created a correlated low rate environment in the mortgage market. Between 2001 and 2007 interest rates declined substantially, increasing home affordability and creating increased demand for housing.
Global Externalities
This US low-rate environment created challenges for other central banks. The Bank of Canada, the European Central Bank, the Bank of Japan, all cut interest rates in correlation with US monetary policy. They had to. If they had not, US dollar inflation would have increased the price of Canadian, European and Japanese exports. This created a "race-to-the-bottom" with interest rates that have fueled global bubbles. Hot money flowed into emerging markets and the BRIC countries (Brazil, Russia, India, China) saw extraordinary growth between 2002-2012. This hot money also flowed into global housing markets. China, Canada and the Netherlands being the most prominent bubbles.
The Canada Conundrum
In Canada specifically home pricing have increased dramatically as a result of the increased affordability granted by low interest rates as well as hot money inflows from the US, China and Europe.
This makes sense from an affordability standpoint.
For example in 2000, a $150,000 mortgage at 7.2%, cost $1235/mo. in mortgage and interest financing.
In 2012, at $350,000 mortgage at 2.87% cost only $2000/mo. in mortgage and interest. In effect, while the value of the asset increased 200% between 2000-2012, the cost of owning the asset grew at a much slower pace, 62%.
This low interest rate environment is creating bubbles in many markets, but none so obvious as housing. This is a very troubling asset class to have a bubble, because unlike the dot com bubble, this bubble hits consumers most, not speculators. In addition, houses are often used as retirement savings accounts and so any decrease in value can have very deleterious effects on wealth.
The Turn
A low interest rate environment is likely to persist for the foreseeable future. The Bank of Japan is using negative interest rates as the first arrow of Shinzo Abe's plan to exit deflation and return Japan to growth, the European Central Bank is dealing with the sovereign debt crisis in the periphery and requires ultra-low interest rates to ensure the Euro doesn't collapse as a currency, and the US has not even exited "extraordinary measures" and quantitative easing (buying Treasuries with newly printed money). Overall this indicates that ultra-low interest rates will persist for the foreseeable future. However, they can't continue forever and there is a very real risk of stagflation.
What happens when interest rates begin to rise? If you look at the cost of mortgages, you can immediately see the implications. Increase the ultra-low rate of 2.87% to a low 5.5% interest rate and the home affordability index changes substantially. The $350,000 mortgage now increases from $2000/mo. to $2500/mo. If they return to a normalized 7.5% interest rate, $2951. This will leave many people overextended.
While a 30% decrease in affordability is not dangerous, and will not lead to a crash in the Canadian market, it does change the long-term outlook for housing as most people buy a house based on what they can afford monthly.
For example, the couple that could afford a $350,000 home at 2.97% interest rates, can only afford a $240,000 home at a normalized rate.
When you look at the cost in the Greater Toronto Area (chart below), or any other metro area, that puts home affordability out of reach for a large segment of the population. As a result, this will lead to a long-term secular bear market for housing in Canada.
While the Bank of Canada is doing what they can to ensure a soft landing for the housing market, this soft landing is going to be maintained through "asset price stability". What that means is that the cost of an asset will remain the same, but not keep up with the decline in purchasing power as a result of inflation. This way the banks will avoid a downturn in the market, even though fewer people can purchase a home and prices will be falling in real terms. Basically creating a wealth illusion to avoid a hasty rush to the exits.
Hot Money in Canada
The big question is the foreign hot money - when the growth slows, will they stay in the asset class? To date, global central banks have pumped almost $7 trillion in liquidity into the market. That money is chasing returns, as 1% in bonds is not enough for high net worth individuals or institutional investors to counter the inflationary effects of QE. As long as the housing market is growing faster than that, Canadian homes will be viewed as a bit of a safe haven. As soon as growth slows to 1-2% from the current 4-7%, the view of the asset class will change and there may be a meltdown, especially in the condominium market which has absorbed the majority of foreign wealth (Vancouver, for example, has an entire condo development that is sold, but only 25% occupied).
Threading the needle is very difficult, and the meltdown will likely start in 2016-17. Will this lead to a crash or just a long period of stagnation in Canadian housing? Ceteris paribus, stagnation. However, with concerns about shadow banking in China, the Chinese housing bubble, the fate of the Euro, the unwinding of QE the world remains a very difficult place to navigate.
